Pop quiz: You’re at an investor’s conference. The attendees are mostly “retail” investors who channel their money into stocks and mutual funds. You’re friends with a broker who works at the firm sponsoring the conference, and he has asked you to be in charge of handing out nametags to the attendees. You show up punctually to supervise all the pretty college girls who have signed up for the registration booth on the chance of zeroing in on Mr. Right. Life is good.
Suddenly your broker buddy rushes up to you. Bad news. The senior partner who was going to field general questions in a Q&A session had a family emergency and she is a no-show. Your friend asks if you can step in and host the session. “Uh.. uh.. yes, I.. I think I could fake my way through the Q&A. How much time do I have to prepare?”
“Fifteen minutes,” your soon to be ex buddy replies.
Fast forward 15 minutes. There’s a stage. On the stage is a podium. Behind the podium is a rising star in the brokerage industry who’s just completed a talk on why the last big money in this mature bull market will be made by shorting high-flying stocks. He exits the stage to a smattering of applause. You approach the podium at a relaxed pace. Relaxed? Why is that? Did your friend have a pocketful of Klonopin standing by? No. The last speaker just gave you an idea on how to circumvent the maelstrom you are about to wade into. Your finely tuned Jedi senses have given you clairvoyance enough to be cognizant of the first question that will likely be asked. If it is, the audience is yours.
You’re on. “Good day, ladies and gentlemen. This is the Q&A session. Who would like to be the first to ask a question?” An elderly woman in the front row raises her hand faster than you can say blueberry pancakes. She reminds you of the demanding “Where’s the beef?” lady from the old Wendy’s commercial. The senior citizen fires her question. “Is TSLA a safe stock to put my money into? It’s a worry because I hear it’s one of the most shorted stocks on the exchange.”
The room goes dead quiet as all eyes turn toward you. That was it! That was the question you hoped would be asked. Everyone and their grandmother are looking to buy Tesla stock, and given the reception this crowd just gave Mr. Knowitall, most of them likely own shares in TSLA. “Good question,” you calmly respond. “Let me see a show of hands — how many here understand what short selling is?” Well over half the audience raise their hands. “OK. How many really truly understand how to short a stock or a market?” Several arms drop. Less than half are still raised. “OK. How many people here understand why some of the best rocket fuel to make a stock to go up, way up, is the act of short selling the stock?”
Most of the hands drop. So do some jaws. OK, you still have the audience’s rapt attention. It will be easy to run out the clock speaking about something you at least have some experience with. Plus, it’s a chance to impress those lovely registration ladies with the contrarian line of logic you’re about to lay on these people. At a minimum, all you have to do is explain the dangers of short selling in a manner that tops what these investors get from the boob tube. Putting it that way, the task should be a cakewalk. The bad feeling you had about the situation you’ve been thrust into unwinds further.
“Well, believe it or not, if you really want to get your arms around short selling, you have to first put your arms around a bushel of corn.” A slightly perplexed expression surfaces on the faces of the attendees. “Not literally, but figuratively. Let’s set the wayback machine to mid 19th century America. At that time the country was of course an agrarian economy. Farmers grew corn and other food commodities for a growing population. They often sold their crops to a third party that acted as a middleman between the grower and those who bought the crops wholesale, such as other farmers who used the corn to feed their livestock, and to distributors such as food canning companies who used the corn to feed humans.
“There was one problem with the system. Agricultural prices fluctuated wildly. The supply of corn, the demand for corn, crop yield, weather, and a variety of other factors caused the price of corn to go up and down. This was an issue for both the farmer as well as the middleman. The farmer was hesitant to plant corn for fear the price would drop before the harvest. The middleman was hesitant to commit to taking delivery of the crop out of concern prices might go up and his customers could not afford corn.
“A solution that actually dates back nearly 4,000 years to the ‘Code of Hammurabi’ was employed. The farmer and the middleman decided to agree on a price for the corn before the crop was planted. The two parties decided on the price for a given number of bushels, wrote those amounts down, and shook hands. The farmer was happy because he knew how much his crop would bring even before he planted it. He was short the amount of corn needed to fulfill the contract, but in time he would plant and harvest the required amount. The farmer could also take the piece of paper with the numbers on it to the bank and borrow some money for seed, to pay helpers, or whatever it took to help insure the crop came in. That is, if the banker trusted the farmer … and the middleman.
“The middleman was just as happy with the idea of a contract because he was guaranteed to buy the corn at a certain price. He had only given the farmer a small down payment to lock in the price and didn’t need to pay in full until harvest. The middleman had to wait a long time to take delivery of the corn, but in the meantime he was able to make deals with his customers ahead of the other middlemen, thereby getting a leg up on the competition. Since the paper contract was derived from the commodity it represented, the instrument was an early form of a derivative.
“This system wasn’t perfect but it helped bring food to market in a more orderly fashion. One drawback was that the commodity derivative market was illiquid because there was only one buyer matched to one seller. It was hard to get out of the contract if the need arose. This deficiency spawned the idea of a clearing house where commodity contracts could be auctioned off to multiple bidders. This was a boon to the market because third parties interested in speculating that the future price of corn would drop in price entered the market by creating a contract for future delivery of corn, even though they weren’t farmers. This is known as a naked short. Other parties would buy these contracts, even though they weren’t in the food business, if they thought the price of corn was going to rise. These ‘greedy’ speculators added liquidity to the market.
“To make a long story short, the first clearing house was set up in Chicago and it evolved into what we now know as the Chicago Board of Trade. The contracts — where one party who is short the promised commodity is matched with one buyer who is long the commodity — are termed futures contracts. If the price of the underlying commodity goes up after the contract is created, then the party that is long can sell the contract for a profit because it has gained value — someone could take delivery of the corn at the agreed upon lower price and then turn right around and sell the grain at the higher market price. Conversely, if the commodity drops in price, the party that is short can sellout at a profit.”
The Wendy’s grandmother stands up. “I understand how someone who is long can sell the contract for a profit if the price of corn goes up, because the contract holder has the right to buy the corn at the old — lower — price. But I just can’t fathom how the short seller makes money when the price of corn drops?”
“Same reason,” you retort. “The party who is short has a contract that says the long must pay, say 50¢ a bushel, for the corn. If the price of corn has dropped to 25¢ by the time the contract matures, the short party can buy the required amount of corn at the market price of 25¢ a bushel and then collect the agreed upon 50¢ a bushel from the party on the long end of the contract.”
“I see,” says the Wendy’s lady. “That makes sense. I never really understood the short side of a contract before. But what the hell does all this talk about commodities have to do with the price of bananas on the moon? What I mean is, how does this information address my worry about buying stock in Tesla?”
You respond, “All you have to remember from this conversation is that the naked short seller has to go out and buy the corn at market prices in order to fulfill the contract.” (This is a simplification because the short seller could also just sell the contract, but the point being made in this article is the same nonetheless). “The whole game for the naked short seller revolves around someone being willing to sell the corn to the short seller when needed … at a favorable price.”
“Now we know enough about short selling to apply the knowledge to the stock market and have it hopefully make more sense than when the bobbleheads on that financial channel discuss the topic. So, how do you short a stock? Stock certificates don’t exactly grow on trees, do they?” The audience lets out a little giggle.
“But to sell a stock short you somehow have to sell shares you don’t own. Otherwise the sale would leave you in a net zero position on the stock. There would be no position to liquidate later. The way shorting stock has traditionally been done is by borrowing the shares from a party that already owns stock in the company. A clearing house (for example your broker) will find someone willing to lend out their shares, with the promise that the shares will be returned at some point in the future. In exchange for this service the stock owner (and of course the clearing house) is paid a nominal fee. In effect, the owner of the stock garners a small income stream for their shares.
“Once the short seller has possession of the shares, they will sell those shares into the market. This generates an immediate cash flow into the short sellers account. Now it’s a waiting game. If the price of the stock drops, then the short seller can use the cash to buy back the stock at the lower price, pocket the difference, and return the shares to the owner. Notice that the short seller didn’t have to put up much money to make a profitable trade. In fact, the short seller was net positive cash the whole time. This is one key to the difference between buying stocks and selling stocks short. If you are dead certain a company is a real turkey and is sure to crash and burn at some point, this seems a pretty clever strategy!
“But wait. There’s just one teeny tiny problem. The share price may go up instead of down. At some point, Mr. Clever may need to cut his losses and buy back the shares for more than he sold them for. Right? And when he goes to repurchase the shares, he becomes … a buyer. He’s become the very entity he hoped was going to retreat from the market. The basic law of supply and demand says that for the price of something to go down, fewer people must desire it. Yet here Mr. Clever is buying shares of a stock that is already rising due to additional buying pressure.”
That grandmother in the front row has stood up again. “What’s the big deal? Buying and selling shares takes place all day long.”
“True,” you respond, “but don’t forget herd mentality. What if a lot of people were to short the same stock? What if you had a stock that was such a turkey, such a total loser, that a significant number of people had determined that it was only a matter of time before the market would figure out that the company was due to go bankrupt … with the stock possibly going to zero? And what if that stock was a high flyer, meaning it had been bid skyhigh before the market came to realize that the business model was flawed? In this case, the shorts, in their confidence, could be heavily weighted on what is referred to as a crowded trade.
“But what if the majority holders of the company’s stock don’t share the notion that the company is doomed? What if they don’t dump their shares? What if a stream of good news comes from the company — like new products being delivered — that generates fresh buying of shares? What if the share price continues to rise after the shorts have gone all in?
“The answer is easy. At some point, when the pain is too great to bear, the short sellers have to get out of their losing positions. Unlike those that are long the stock, where the worst that can happen is for the share price to go to zero (limited risk), there is no cap on how high the share price can go. This is the constant worry of the short seller. When the pain is too great, the shorts become buyers. En masse. Once the psychology flips and the shorts start heading for the exits, it can be a stampede.” Because nobody wants to be last one out the door of a burning building.
“It’s like dominos. Buying back shares begets more buying back shares, as demand rises and price follows. If you go back to that example of a naked short position in the corn contract, the party can only cover the trade if they can find someone to sell them the corn they need, or get someone to buy the contract off them at a favorable price. Either way, the effect is the same. Once the players in the corn market catch on to what the shorts are trying to do, they become less willing sellers. Supply dries up. There’s little corn to be had. The short sellers end up taking it in the shorts because they have to pay a premium to buy the corn or liquidate the contract.
“So, too, with the short sellers of a stock. The shorts are already in trouble because the stock’s price has moved against them. They get in more trouble when panic sets in and they all head for the exit gates at once, bidding up the share price dramatically. That activity tends to force the remaining shorts to liquidate their positions. And they all fall deeper into the hole they’ve dug for themselves when the market wises up to what they’re doing and market makers become reluctant to sell shares, forcing prices even higher.
“This type of market action is termed a short squeeze. The carnage in such an event is legendary (google ‘hunt brothers silver’ for an example). So I ask you now, dear audience, if it turns out that the most shorted stock on the NASDAQ, TSLA, is perceived by enough people that the company is not some Ponzi scheme after all, but is in fact a somewhat solid company, delivering product, making a per-unit profit, do you see now how maybe the shorts have more to worry about than those of you invested in TSLA on the long end?”
Thunderous applause of understanding and relief break out. Grandma is on her feet again. “I get it! I’m not worried anymore. It’s unlikely that short sellers alone can kill a company that wasn’t already scheduled for termination from its own folly. Perception and fact intersect at some point. But give us the frosting on the cake. Has the price of TSLA risen due to a short squeeze?”
In part 2 we will discover the other major reason the shorts can drive up the price of a stock.
Recommended reading: Nobody Knows Anything: Investing Basics: Learn to Ignore the Experts, the Gurus, and other Fools, by Robert Moriarty
Disclaimer: The author holds no positions in TSLA.
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