The art of selling short

In turbulent times, a good way of sniffing out which companies are likely to fail is to see how much of their stock is being sold short

When do short sellers strike?

When they spot a company that looks too generously valued by the stock market. Last month, for example, as the world went crazy for Pokémon Go, the share price of Nintendo, which had been stable for years, more than doubled in 13 days – an astonishing, almost insane surge for a mature business. But what most investors hadn’t noticed in their excitement is that Nintendo doesn’t actually own Pokémon Go, only a small piece of it. The level of short selling in Nintendo surged threefold, and within days the stock had slumped again, losing most of its gains.

What else do they look out for?

They look for companies that are being so poorly or dishonestly run, they could end up going bust. It was short sellers who first realised there was something fraudulent about Enron (the US energy giant that collapsed in 2001), and who early on spotted the flaws in the US housing market and the rotten nature of subprime mortgages. One of them, John Paulson, made $5bn by placing contrarian bets against the market. George Soros famously made £1bn by shorting sterling before Black Wednesday in 1992. He didn’t do the same before Brexit, however, because, like most professional investors, he wasn’t expecting the Leave vote. But, as a hedge, he’d shorted Deutsche Bank, whose shares crashed on the result, reportedly making Soros tens of millions.

And how do short sellers make a profit?

In the opposite way that most investors do. Conventional investors “go long”: they buy stock (or currency or assets) in anticipation that its price will rise and that they’ll make a profit when they sell it. If you “go short”, by contrast, you’re looking to make money from a fall in the price of a stock – or a currency, or even a whole stock market (see box). To do this, you borrow – from someone with stock in a company you think is overvalued – a given amount of shares, pledging to return them at a specified future date. You then sell those borrowed shares on the open market, hoping that when it comes time to buy back the same amount of shares and return them to their owner, their value will have fallen and you’ll have to pay far less than you sold them for.

Can this be done with more or less any sort of share?

Yes. For example, imagine you run a hedge fund and want to short Facebook. Your teenage daughter is always telling you that all her friends use Snapchat and regard anyone still on Facebook as a middle-aged loser. You also think Facebook will never get the penetration in Asia that it’s banking on. All in all, it’s a clear shorting opportunity. So you instruct a trader to borrow Facebook stock in the marketplace from someone who owns it – a pension fund, say, or some other big institutional investor – and then to sell it in the market on your behalf. You then cross your fingers that the Facebook share price will fall before you have to buy back the stock and return it to its original owner.

What’s in it for everyone else?

For the owner of the stock who lends

it to the short seller, lending stock out is a way of making extra income: they earn a fee and are still entitled to any dividends that fall due. And needless to say, the whole money-go-round is a nice little earner for the banks, whose prime broking divisions specialise in finding stock for short sellers to borrow, lend them securities to trade with, and help structure the trades – all for a fee.

Isn’t all this incredibly risky?

Absolutely. The key point about shorting is that it’s quite possible to lose more than 100% of your initial stake. Invest £1,000 in a firm which then goes bust, and the most you lose is £1,000. But if you short a stock to the tune of £1,000 and the stock were, say, to surge fivefold, you’d need to find £5,000 to cover your short position. This is why very few ordinary investors have access to the kind of stockbroking account that permits short selling (though they can use spread betting to the same effect). Short selling is normally confined to hedge funds and other professional investors authorised by regulators to speculate using borrowed money. Funds of this kind often use it as a tactical “hedge” against a long position – i.e. a way of minimising the risk involved in taking a big investment in a stock.

Why is shorting so vilified?

Many find the act of betting on a share price drop – willing a business to fail, in effect – fundamentally distasteful. Profiting from others’ misfortune is not a good look. And short sellers are often accused not just of taking cynical advantage of the market, but actively manipulating it – that is, of talking down businesses so as to make profits from price falls. (But remember that research analysts who claim a company is overvalued – and should be shorted – are subject to the same laws of defamation as those who say it is undervalued and should be bought.) Short selling is also held to aggravate the volatility of markets, which is why it is often the subject of partial or total bans, typically when markets are falling. Such bans are of doubtful utility, however: they just tend to result in lower market liquidity (i.e. make it harder to trade) and higher trading costs, and to damage investor confidence.

What is the case in favour of short selling?

The level of “short interest” in a stock (the percentage of shares out on loan – usually no more than 1% or 2%) can be a useful indicator for investors of how a company may be faring. Some companies are so bad or so dishonest that they deserve to fail – and short selling gives investors an incentive to root out the stinkers and expose the frauds. One of the first people to suspect wrongdoing at Enron, the short seller James Chanos, runs the investment firm Kynikos Associates, named after the Greek word for “cynic” – and being cynical about what corporations claim may be no bad thing, even if short sellers do profit from the price falls triggered by their sceptical analyses. No doubt some short sellers are avaricious shysters, but in the world of finance, that hardly makes them unique.