Article explaining the practice of Short Selling of shares
This is a republication of an item used in Market News 8 October 2012
Last week (September 2012) there was an article in the media (by Chalkie on www.stuff.co.nz) about short selling of shares and the failure of the NZX to disclose this market data, a point that I agree with.
This prompted several people to ask us what ‘short selling’ means and why this activity is important to financial markets.
I recall touching on this subject once before when discussing ‘Repo’ markets (securities lending) and why this too is an important market, so forgive me if you read that item and find this item to be a repeat lecture.
To open with the conclusion; short selling is the act of selling something that you do not own. (isn’t that illegal? – Ed).
Maybe it should be, but no, it is allowable because financial markets have decided that securities (shares, bonds etc) may be treated in the same way that you and I treat cash; we may have some of our own cash that we can use (a ‘long’ position), or we may borrow cash from others to use (a ‘short’ position).
A ‘long’ position is a surplus position. If I buy 10,000 Telecom shares my investment position is +10,000 TEL.
A ‘short’ position is a deficit or negative position. If I start with a position of zero Telecom shares, then I sell 10,000 Telecom shares, my investment position is -10,000 TEL.
If I choose to have a ‘long’ position of 10,000 TEL, I hope to profit from ongoing dividends plus any capital growth in the value of the company, measured by a rising share price.
If I choose to have a ‘short’ position of 10,000 TEL, I hope to profit from a falling share price (buy them back at a lower price).
Clearly, a ‘short seller’ must have the view that the TEL share price is currently too high, and should fall, for them to profit because they are not collecting dividends, and they are paying a marginal fee to borrow the TEL shares they sold (more on this below).
The ‘short seller’ must borrow some TEL shares to make delivery to the person they sold the TEL to.
Here is a role-play for you (which may prove easier to follow if you draw it on a page using three boxes, one per person per box, plus arrows to follow the various movements):
Adam holds 10,000 TEL shares (‘long’).
Wally (no criticism intended) believes the TEL share price will fall so he sells 10,000 TEL shares, that he does not own (now ‘short’), to Victoria, who pays cash.
Wally borrows 10,000 TEL shares from Adam (to pass to Victoria) and agrees to pass back all TEL dividends to Adam PLUS pay a rental fee for use of the TEL shares, say 2.00% per annum.
Adam asks Wally for some collateral (perhaps cash) as security against the use of the TEL shares, just in case Wally ‘gets it wrong’ and runs off to Brazil to hide.
Without wanting to confuse the maths with tax, you can now see that Wally must be very confident with his view about a falling TEL share price because the implied cost of his TEL investment position is about 12% per annum (based on last year’s dividends for TEL).
Wally may well have done his research on TEL but he is a brave man in my opinion. Even braver when you consider that the cash he generates by selling TEL can only be deposited now at very low short term interest rates, so the true cost of holding his ‘short’ position may well be as much as 10% per annum, which I consider to be a heroic position to take.
If you’ll allow me to dovetail this piece in with my comments during September about the likelihood of very low interest rates, for a very long time, providing further upward pressure to the price of many shares, you should see two pressures fighting against Wally; the risk of higher share prices plus the risk of lower returns on his surplus cash balance.
Put differently, being ‘short’ of assets and ‘long’ of cash in a 0-2% interest rate environment is not a strategy that I wish to employ!
There is another risk that Wally needs to consider too, the one that see Adam increase the rental fee for borrowing his TEL shares. When owners of assets, like Adam, learn that borrowers of assets, like Wally, may be struggling the natural reaction in financial markets is to apply more pressure to hurt Wally.
In my humble opinion, now, in the current financial market conditions, would be an excellent time for Adam (or others who lend their shares) to double the rental on the shares that they lend, or ask for them back, and try to squeeze out the share sellers who have been trying to damage the value of other peoples shares!
This may all sound a bit vindictive and nasty, but this is the hidden truth of how financial markets behave.
Circling back to Chalkie’s point about poor disclosure by the NZX. I totally agree that information about holders of ‘short’ positions, and the scale of those positions, must be disclosed in the same way that the register of those with ‘long’ positions must be made public (and is thus used by the scammers!)
If financial markets are entitled to know the details of investors with ‘long’ positions, they are similarly entitled to know the details of investors with ‘short’ positions. Any other outcome would be unfair, and thus inconsistent with the new playing field objectives of the Financial Markets Authority.
If you are wondering about who profits from the scenarios above, well, the answer is sometimes, Adam and Victoria and sometimes Wally, but always the brokers and investment bankers, by way of increased turnover and volatility
