Short Selling, Naked Short Selling, & the Short Squeeze — Investing Ideas
Short selling is an integral part of the modern financial system. Massive sums are made and lost every single day because of this unique investing tool. Some argue that it is a vital part of the free market. Others say it’s greedy and cynical. But one thing is for sure: short selling remains mysterious to many investors.
So, what exactly is short selling? Why do people do it? The answer is quite simple. Short sellers seek to profit from a price decrease in a security (for instance, a stock). If the price of the stock increases, the short seller loses money. Conversely, if the price decreases, the short seller makes money.
The standard short sale which any ‘retail investor’ can engage in is known as a “Covered Short Sale”. Let’s take a look below at the steps involved:
Covered Short Sale
To further simplify, think of steps 1 & 2 as the “borrow” stage, and steps 3 & 4 as the “cover” stage. During steps 1 and 2, shares are borrowed from a lender and then sold on the market. The short seller pockets the amount, in this case $100, which the market Buyer pays for the stock.
Now the short seller waits. If they are lucky, the stock price falls. At this point, the short decides that it is time to realize their gains. They do so by “covering” (ie. executing steps 3 & 4). In step 3 the short purchases the stock back from a market Seller (in this case for $50). Subsequently, in step 4, they return the share they borrowed from the lender. Voilà! $50 in the bank.
Due to the nature of this maneuver, a short sellers potential losses are unlimited. If you buy a stock for $100 you only stand to lose $100. However, if you short a stock at $100, your losses are not limited at any number. This is due to the fact that a stock can continue to rise indefinitely, for all intents and purposes.
Naked Short Sale
The primary function of the naked short sale is the same as the covered one: to profit from a share price decline. There is really one big difference: the stock is not borrowed before it is sold short.
If you’re scratching your head, you’re not alone! Naked short selling is a bit of a tough one to get your head around.
In the above scenario, in step 1, the stock is “sold” to the buyer, who pays $100. However, the short seller above does not actually have the stock! Therefore the stock is not actually delivered at this time. “FTD Stock” in the above stands for “Stock Failure to Deliver “ which is the technical term for not delivering the stock you owe to the buyer.
Later, in step 2, the stock is purchased from the market (analogous to step 3 of the “Covered” example). Subsequently, it is delivered to the buyer to settle the trade.
Regulations have significantly tightened since the global financial crisis. Therefore, a naked short sale as blatant as the above will not pass scrutiny. However, naked short selling continues to happen via more complex and cunning variations on the above. Of course, the standard retail trader can never execute a naked short sale. It can only ever be executed by a so-called “Sophisticated Investor”, for example a hedge fund.
Now, what about the short squeeze?
Short Squeeze
The short squeeze describes a scenario where many short positions seek to cover at the same time, driving the stock price up dramatically.
Step 1 is a prerequisite for the Short Squeeze: significant shares of the company must be sold short. If this is the case, then a rapid, unanticipated price rise (step 2) causes shorts to “cover” their position (step 3). As you know, “covering” is a process which includes buying shares. This buying pressure (aka demand), forces the stock even higher.
Specific Cases
In certain cases, such as the GameStop (NYSE: GME) short squeeze in 2021, other factors collide and add fuel to the fire. After the start of the squeeze, the fact that many GameStop holders refused to sell their shares to a short cover meant that the price rose even further. Beyond this, naked shorting may have created unrealistic buying pressure at the short squeeze due to the fact that shares needed to be bought which were not confirmed to exist.
Another case worth mentioning is the Volkswagen ( XETRA:VOW) squeeze of late 2008. According to many sources, this short squeeze briefly made Volkswagen the largest company in the entire world by market cap! At the risk of going on a tangent, I will not go into detail on this case. However, you can check out the many interesting articles on this case available on the internet.
Now you know the basics of short selling. So that next time someone says “The short squeeze is on!” you know how to react! And the next time you anticipate that a stock is going to the zero, you know what maneuver you can turn to: the short sale.
Until next time, invest wisely my friends.
Originally published at https://www.investingideas.ca on March 3, 2022.
