In the financial world, it’s when things go spectacularly or unexpectedly wrong that we hear about it in the news. A case in point is the GameStop story which rocked markets recently and put short selling back in the headlines.
What is short selling
Short selling occurs when an investor, expecting the share price of a company to fall (ideally significantly and quickly), borrows a parcel of that company’s shares from a stock lender, creating a liability to return the same parcel of shares in the future. The investor then sells those shares on the market, but at some point in the future they must repurchase those shares to give them back to the stock lender. If all goes as planned and the share price falls between when they sold the stock and when they repurchase it, they pocket the difference in profits.
But if the company’s share price goes up, the short seller may be forced to repurchase the stock at a higher price than when they borrowed it – then the short position becomes a loss. If trading volumes in the company are small and the short position is large, this can create a “short-squeeze” leading to a rapid spike in a company’s share price. Depending on how big the short position and how much the price goes up, this can result in millions in losses for the short-seller.
Which is what transpired with GameStop. Hedge fund Malvin Capital and others took a short position in the computer game retailer on the presumption that their bricks and mortar stores could not survive in that format. At the same time, retail activist investors from social media platform Reddit cottoned on to this and started buying GameStop, quickly driving up the share price in what’s become known as the “revenge of the nerds” against Wall Street.
This resulted in a short squeeze and the hedge funds rushed to close out their positions to minimise their losses. But this had the result of driving the share price higher and as the short positions to be closed out accounted for over 1.5 times the actual stock on issue (something that can’t happen in Australia), the share price just kept going up, from around $US20 to nearly $US350. As result, the hedge fund incurred losses of $US20 billion on their GameStop positions. Ouch, that’s got to hurt.
Is short selling good or bad?
The media often likes to present short selling as a fight between good and evil (i.e. short sellers are bad and retail investors are good). This view of short selling comes from concerns about hedge funds, who have been criticised for taking short positions and then trying to manipulate or pressure markets, sometimes based on unfounded facts, to drive a company’s share price down. While there is certainly evidence of this undesirable, if not criminal behaviour, short selling as an investment strategy is not inherently bad. It has been used by prudent fund managers for years and there is a place for it in balanced portfolio management.
What role does it play in a balanced portfolio?
Short selling can be an effective way of enhancing returns rather than simply buying companies for long term growth. We know that share prices do decline at times and not all share prices rise at the same time or to the same extent, but like any investment strategy, it’s all about how the short sell is planned and executed and how well the risk is managed.
At FMD, we work with a number of fund managers who use a ‘long/short’ approach, where a strategy like pairs trading is utilised. This is where, for example, an analyst may target a bank’s shares that appear expensive and set up a short position to benefit when the prices drops, ultimately enabling them to reinvest those extra funds in a bank that looks more attractively priced for the long term.
From there, managing the trade is all about strong risk controls. In this example, if analysts see the short position start to rise 2 or 5%, they are ready to close out their short positions before losses accumulate. The benefit for investors is that short selling enables fund managers to take advantage of all of their best insights about a company, including those that appear very expensive or may have a clear catalyst for a price fall, such as if merger discussions cease between two companies.
Remember to ignore the noise
The GameStop story was a great example of short position going spectacularly and unexpectedly wrong and a fascinating story to read about. It is also a timely reminder that there is lot more to most investment strategies than what you can read in about in the news. Savvy investors get great advice, benefit from active portfolio management from a diverse range of top fund mangers, and importantly - play the long game.
General advice disclaimer: This article has been prepared by FMD Financial and is intended to be a general overview of the subject matter. The information in this article is not intended to be comprehensive and should not be relied upon as such. In preparing this article we have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained on this article to particular circumstances. FMD Financial, its officers and employees will not be liable for any loss or damage sustained by any person acting in reliance on the information contained on this article. FMD Group Pty Ltd ABN 99 103 115 591 trading as FMD Financial is a Corporate Authorised Representative of FMD Advisory Services Pty Ltd AFSL 232977. The FMD advisers are Authorised Representatives of FMD Advisory Services Pty Ltd AFSL 232977.