How to Play the Market by Shorting Stocks
Often times, we hear from analysts, writers or other pundits about a certain stock’s high short interest, and how that can signal bad times ahead for a stock.
What exactly does a high short interest mean, and does it always signal that a stock is about to fall because people are betting against it?
In this article, I’m going to go over all the ins and outs of what shorting a stock means, and more importantly for us, how sometimes this high short count is not caused by those necessarily betting against a stock, but rather from the financial institutions that have loaned the company money and have received convertible bonds or warrants in return.
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Why would a financial institution that is lending money bet AGAINST the stock of the company that they just loaned money to?
Good question! This is one of those small little nuances on Wall Street that often confused me, and left me scratching my head wondering why a seemingly “great” stock had so many people betting against it.
I’ll break down this article into 4 parts:
- What Does Shorting Mean? Essentially you’re betting a stock will go down
- What Are the Risks? There are many, since shorting is risky!
- Why Do Financial Institutions Short? It’s a strategy to hedge risk, and lock in profits
- Bottom Line: Shorting is a risky, but necessary part of the market
A Quick Review of Shorting a Stock
Essentially, you are betting that the stock is going down. But, before I get into the nitty-gritty of why financial institutions would bet against a company that they just loaned money to, let’s first go over exactly what the term “shorting” means, and what it entails.
Here’s a common definition of shorting a stock, or being “short”:
- The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.
- Opposite of “long (or long position)”.
- For example, an investor who borrows shares of stock from a broker and sells them on the open market is said to have a short position in the stock.
- The investor must eventually return the borrowed stock by buying it back from the open market.
- If the stock falls in price, the investor buys it for less than he or she sold it, thus making a profit. (Taken from Investopedia.com)
Taken further, shorting a stock essentially means that you are taking the opposite side of the trade than when you traditionally purchase shares in a company, to hold for long term investment. If, for instance you think a stock is way overvalued, or is going to run into rough times ahead, you would then “borrow” the shares at the price where the stock sits today, and then sell them on the open market hoping to purchase them back later at a lower price.
Let’s use a quick example: XYZ Corp. is trading at $30 per share, but you think that because of high insider selling, a faddish product, and deteriorating fundamentals at the company, this stock is headed to $0 in a heartbeat. So you enter a trade in your brokerage account to “sell short” 100 shares of XYZ at $30 per share. This costs you $3,000 plus commissions. You are now “short” the stock, and are betting that it will DECLINE in value.
In a few months, XYZ indeed falters, and the stock trades down to $20 per share. Sensing a possible turn in the business, or just wanting to take your profits off the table, you “cover” your short position. What this means is that you buy back the shares at the current stock price, in this case $20 per share. So, what you have essentially done is make $10 per share in profit on XYZ’s stock decline, or $1000 excluding commissions.
Sounds Simple Enough. What Can Go Wrong?
Shorting stocks is extremely risky! It all sounds pretty glamorous, but shorting stocks is not for the faint of heart, nor those that are not watching their investments on a daily basis. There are many risks associated with shorting stocks that you don’t get with “going long” or buying shares in a traditional manner.
Some of these risks include:
- Unlimited Potential for Losses: This is a nasty potential risk. If a stock RISES instead of falls, when you have sold the shares short, you could essentially lose an infinite amount of money.
In reality, what is most likely to happen is that you would get your shares called back by your brokerage firm before your losses swallowed you alive, but by then you are already sunk.
Let’s take our example from above. Say XYZ Copr. goes from $30 to $60 and you are still short. If you then bought back your shares to “cover” your position, you would lose DOUBLE your initial investment! It would cost you $6000 to cover your position, while it only cost you $3000 to start the short position in the first place. So you can see how your losses can keep accelerating as the price of the stock increases instead of decreases!
- Limited Upside: Along those same lines, your potential for profit is limited. The most you can make shorting a stock is 100% of your investment, and this only occurs if the stock goes to $0, which will hardly ever happen even with the worst companies.
- Margin Calls: When you short a stock, you must have what is called a “margin account” which means you are preapproved by your broker to have a sort of revolving line of credit to buy more stocks than you have money to buy. Think of this as money you have access to if you want to go above and beyond the cash in your account.
For shorting stocks, it is a requirement to have a margin account in order to “borrow” against the sold shares that you are now short. Here’s where it gets even more potentially risky however. If you are using this margin to purchase more stock, either long or short, brokers have certain thresholds that they use when monitoring their risk, and assessing your ability to pay back that loan with the current value of the stocks in your portfolio.
If you use too much margin, and your stock that you have bought long go down in value or vice versa, the broker institutes what is known as amargin call. What this essentially means is that the broker feels that your risk to the market is too high, and the stock value in your portfolio is insufficient to cover your margin requirements, which are typically 50% of your total cash value.
So What happens? Well, the broker forces you to either deposit more money into your account, or, and this one hurts, sell the stock you have for what usually is a large loss to bring the account back to within certain requirements. The danger of a margin call is that you will lose more money on an absolute basis, than you invested initially.
For example if you only had $1000 in your account and used margin to buy $2000 worth of stock on a long position (you borrowed a matching $1000), if the stock’s value is cut in half and you are forced to liquidate your position, you would be left with nothing!
Why? Because when you sold your stock, it went from $2000 ($1000 of your own cash, and $1000 that you borrowed from your margin account), to $1000. When you sold the stock, that $1000 goes straight to the broker to pay off your debt, essentially leaving you with $0! You leveraged your money in your account to buy more stock, but because of the decline in the stock price and the margin call, you lose all your money!
Of course, the same works on the upside. If the stock doubled in price, you would sell for $4000, pay back the $1000 that you borrowed, and pocket $2000 in profit, essentially TRIPLING your money with only a double in the stock price. This is both the power and the pitfalls of using margin.
In the case of shorting a stock, when the broker gets nervous, or you set off predetermined caps or set points in very sophisticated risk models that brokers use, you’ll get a margin call, and you usually have 1-3 days to make a decision. You either add more money to your account, or sell off some of your shares to meet your margin requirement.
What happens if you don’t do anything? Oh that’s easy…the broker will do it for you! Ouch!
- Short Squeezes: This one is also potentially very damaging.
Let’s say you short a company’s stock and there is also a high short interest in the stock, meaning that there are lots of others that also think the stock is poised to fall. Short interest is defined as the total number of shares held short, divided by the total float. This gives us a percentage. It depends on the stock, industry, and business, but usually anything above 10-20% is considered high short interest. This means that 10-20% of the stock’s total float is held short, or those that are short are betting that the stock will fall.
In a short squeeze, the rising price of a stock forces those that were short to cover their position, least they lose even more money. Most investors that short stocks have a low tolerance for price swings in the wrong direction. So if a stock with a high short interest goes up, and continues upwards, on earnings, good news, or for whatever reason, you can bet that those that are short are going to be heading for the exits.
This “squeeze” as it is known, is when everyone that was short, trip over themselves to buy back the shares before they get further buried under increasing losses. So, more buying ensues and the stock price goes higher, which scares more shorts into buying back their shares which, yep you guessed it, makes the stock price race even higher. If you are long on a stock, this is a thing of beauty. If you are short, it’s another potential risk that you have to watch out for.
- Overall Market Trends: Over time, most stocks rise, not fall.
The most difficult part of shorting a stock is knowing, or getting lucky enough, to time its potential decline. Even crappy companies and stocks will rise in a bull market, and trying to time a decline in stocks, or the market is an exercise in futility. Therefore, those that short stocks need to have a quick trigger finger and institute tight stops on their trades to protect themselves from the downside risk.
The worse part about this risk factor, and what often happens to short sellers, is that over time you are going to probably be right that XYZ Corp. is a bad company with shady management that’s eventually going to trade for $0. The problem is knowing when that will happen. It could take years, months, or the price of the stock could trade up for a time before the fundamentals eventually catch up to the stock price. Fortitude and temerity are required to short stocks.Oh and a quick trigger finger if you are wrong!
Why Do Financial Institutions Short Stocks of Companies They Lend Money To?
Learn to look beyond the obvious reasons for a high short interest. High short interest in a stock isn’t always what it seems. Many of the companies that I research have a considerable or high short interest. Some of them are for obvious reasons, for instance GeoEye
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Let’s use AAR Corp. for our example. Surprisingly, about 20% (7.4 million shares out of 35.4 million total in the float) of AAR Corp. is held short, but there is a simple explanation for this aside from the mere fact of people betting against the company that is heavily tied to the airline industry.
Why are so many shares held short? Well, the primary reason for this many shares being held short is a function of AAR’s convertible notes/debt that they had to sell to raise capital for their acquisitions and cash flow initiatives last year. You see, when a company needs capital to make acquisitions, fund operations or grow their business, they have several choices:
- Straight debt: The company simply borrows money from a bank. This is usually attached with certain conditions, and a high interest rate, depending on the company’s financial situation. This option has not been available to most companies because of the current credit crunch, and if they were able to get money this way, it was at undesirable terms.
- Issue more stock: A company could simply issue more shares of stock on the open market, and raise money this way. The downside with this option is shareholder dilution. You and I certainly won’t like it when our 100 shares are worth less because all of a sudden, the company has flooded the market with more shares of their stock. Think of this as similar to inflation whereby the same dollar buys less milk. You still own a dollar, but it’s worth less.
- Convertible debt: The last way that a company usually raises money is through what is known as convertible debt. Convertible debt is a security that a company issues that gives the holder the right to purchase that particular company’s securities from the issuer at a specific price within a certain timeframe. Warrants are often included in a new debt issue as a “sweetener” to entice investors.
In the case of AAR Corp., straight debt had a higher interest rate than convertible bonds, so companies like AAR prefer convertible bonds to tapping the equity markets and diluting shares, or taking on straight debt. With convertible bonds there is an option to collect interest and the owner of the bond can convert the bonds to shares in company stock if the stock hits a certain strike price, which in this case is much higher than where AAR sits today.
For AAR’s convertible bonds, one of the lots that AAR sold, for example, has a strike price of $35.57, and then the bonds can be converted into shares of stock. Once AAR’s stock crosses that price then AAR has to account for the additional share dilution when they compute their earnings per share, and total share count. When the shares are exercised, AAR pays up to the par value (face value of the bond) in cash, and anything above that they can pay in cash or shares of their stock.
For an example, it works something like this: Share price – $35.57/ current price x total underlying shares = total. Or for an example, using a $40 stock price: $40 -$35.57 = $4.43/ $40 = .11075 x 7.023 million shares outstanding = 723,000 shares that would be added to the total pool of shares outstanding.
In essence, the higher AAR’s stock price goes, the more diluted their stock becomes because more bonds are being converted into shares of stock. AAR also has the option to pay them all off in cash and have no dilution, or some mix of shares and cash. Typically, a bond vs. straight debt is more dilutive, but longer term it’s better for shareholders because it allows the company to borrow money, while giving them lots of time to pay the loan back; all the while giving them favorable terms on that debt that are above and beyond what they would get by using straight debt financing.
In order to continue to grow, AAR needed access to capital, and the high yield markets were closed for new debt with the current credit crunch. On the same token, if they did get a loan, the interest rates are really high right now, so in the end, the convertible debt is much more attractive. In addition, straight equity also didn’t work because of the dilutive aspects of it (no one wants to be diluted as a shareholder!), so convertible debt was a great cross between the two.
What Does That Have To Do With Short Interest?
Great question! Now that that’s all out of the way, I can now explain what this all has to do with what typically looks like a high short interest in a company’s shares. As a result of issuing these bonds, the financial institutions that bought them institute what is known as “hedging” strategies whereby they buy AAR’s convertible debt, and then “sell short” the stock to lock in the difference.
This is what’s known as arbitraging or hedging. It allows the financial institutions that loaned money to AAR to lock in gains, but in order to do so, they have to short the stock, or bet AGAINST it, since they already hold the note worth more than the current stock price. This way, they are guaranteed a certain percentage return on their investment, but in the mean time, it makes it look like AAR’s shares are disproportionately shorted and that there is more negative sentiment on the stock than there really is.
This is the predominant reason for the high short count in shares of AAR, and GeoEye, but not the only reason. Some of the other reasons include overall market malaise, uncertainty in the airline industry, high oil prices affecting AAR’s customers, a declining U.S. economy leading to less demand for flying, higher prices by the airline industry leading to higher costs, and also the airline industry deciding to cut back on flights, and decommission certain gas guzzling aircrafts.
Any or all of these factors are also contributing to the short interest in AAR being so high. But with all that being said, the disproportional amount of short interest in AAR and GeoEye is as a direct result of their debt financing and the issuance of warrants or bonds, instead of borrowing money or issuing more stock.
Bottom Line: Shorting stocks is risky, but necessary
Many traders are very fearful of shorting stocks, and for good reason. By extension, many traders and Wall Street analysts also look at the short interest of a company they are following as a gauge as to the future prospects of that company. A high short interest usually means there is trouble afoot, or at least there are many out there who feel that the stock should be much lower than where it sits today. They could be right, or they could be wrong.
What’s more important than the total short interest in a stock, is where that short interest is coming from, or more importantly, why it’s so high. Wall Street doesn’t work in a vacuum and neither do the stocks that we invest in. There are usually good reasons for a stock that has high short interest, and it isn’t always necessarily a reason based on the company’s fundamentals.
Often times a company has taken on so much debt and issues so many warrants or convertible bonds, that the hedging strategies employed by the firms and banks that loaned them the money, makes the stock’s short interest appear disproportionately high.
Learn to spot when this is occurring when you are doing your due diligence on a stock or company that you are thinking of either buying for the long term, or shorting for a quick trade. I believe that every balanced portfolio, and every active trader, should include some short exposure in their balanced and diversified portfolio, but make sure you know the ins and outs well before ever attempt this strategy.
Chris Fernandez is the founder of PeakStocks.com, a recommendation blog, where he focuses on Micro-Cap and Small-Cap stocks since those are the types of stocks that he believes will earn you the highest return on investment over the long haul. To read a more detailed explanation of his investing style, please visit: PeakStocks.com