Short Selling, Stocks, and You

by JT McGee

Falling stock prices can make you just as wealthy as rising stock prices if you go short. Short selling stock involves borrowing shares to sell, with the understanding that you will buy back stock to repay your borrowing in the future.

Short selling would be pretty awesome if you could do it on things like cars. I’d love to borrow a fully-loaded 2013 car and sell it today to replace it in 20 years. I’d have a guaranteed positive return – there’s no way it’ll go up in value. That sure makes short selling sound great…if you can find someone willing to lend you something that is guaranteed to go down in value.

The Danger in Going Short

Short selling is harder than people think. The math works against you. If a stock goes to $0, you can make a 100% return on your money. If a stock goes higher, you can lose unlimited amounts of cash.

Don’t take this the wrong way, though. I don’t think there are many opportunities to make more than 100% quickly in the stock market – short or long. But consider that if you short a stock to zero, and it takes 10 years to go bankrupt, you’re looking at 7.17% per year. That’s not very good – I mean, it’s probably a little better than you’d get out of the broad market in the next 10 years.

The other danger (other than risking infinite amounts of money to make a finite amount) is the fact that short selling can go horribly wrong.

I love showing people this chart:

Volkswagen went from 200 euro per share to 1000 in a matter of days. So here’s what happened: insiders and major institutions owned most of it. Porsche wanted to own more of it. Short sellers had borrowed millions of shares.

Short sellers were holding nearly 13% of all shares short against a public float equal to 6% of the company. So 13% of shares were borrowed, and only 6% were available to buy back to cover those borrowed shares. That’s what you have to do to cover a short trade: buy back stock to cover.

So Volkswagen spent a temporary moment in time as the most valuable publicly-traded company in the world because of the amount of short interest relative to the number of shares for sale. It wasn’t that the automotive business was a good place to be in 2008. Volkswagen was just a good stock to own when the market couldn’t find enough of it.

Short Interest and You

Short interest really drives the market. When people go short, you get more shares up for sale. When people cover their short positions, you have far fewer available shares for sale. So check out this chart from Schaeffer’s Research showing the relationship between share prices and price levels:

Short interest tends to peak at market bottoms, and trough at market highs. (I’m a little irritated with the data – it shows short interest in billions of shares, but not market value. Selling short a $600 share of Apple should not be equal to a short sale of AMD, which is currently valued at $4.)

At any rate, the relationship between shares held short and market valuations is very strong. Like my new buddy at Schaffer’s Research, I’m starting to think the markets can go even higher just on short sellers buying to cover. It’s not necessarily a good reason for stocks to go higher (European economic improvement would be excellent), but it’s reason enough.

{ 1 comment… read it below or add one }

PK September 17, 2012 at 10:32

Aff, VW, the mother of all short squeezes! I remember reading about it while it was still going on – Porsche’s bid was a surprise (a snake eating a lion). There was at least one suicide IIRC as well.

Crazy stuff.

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