Short And Sweet

Foreword from ShareInvestor

This article “Short And Sweet” by Daniel Buenas was first published in The Business Times on 19 Mar 2007 and is reproduced in this blog in its entirety.

Daniel Buenas examines the gains and pitfalls of selling a stock short

Financial markets around the world had it rough over the last few weeks, and Singapore was not spared either.

A term that is perhaps bandied around a little more during market dips is selling a stock short – otherwise known as ‘shorting’, or taking a short position.

For those unfamiliar with the term, shorting is actually a relatively simple concept: it is about selling shares that you don’t actually own – yet.

Imagine company A has a share price of $10 per share. However, an investor (let’s call him Tommy), believes that the company is overvalued, or feels that world events – such as a sharp fall in global markets – will cause the share price to fall. Since Tommy doesn’t own any shares in company A, what he decides to do is to ‘short’ the shares, or sell the shares first – even though he doesn’t own any.

Let’s assume he sells 100 shares for $1,000. Now, let’s say company A’s stock comes crashing down from $10 a share to $5 a share. At this point, Tommy buys back 100 shares – for a total cost of $500, and then passes the 100 shares to the person who originally bought the shares he didn’t have.

In essence, Tommy sold the shares at $1,000, but bought them back for $500, which leaves him a tidy profit of $500.

This basically reworks the conventional wisdom of stock investment that says ‘buy low, sell high’, into ‘sell high, buy low’, and is one reason why some investors can still turn a profit when markets tumble.

But let’s take a look at a different scenario.

Let’s say that just after Tommy shorted company A’s shares, it announces that it has found a drug that can potentially cure cancer.

Investors are thrown into a frenzy, and before you know it, its share price has soared to $50.

Ouch.

Before the share climbs any further, Tommy decides to cut his losses and closes out the transaction. In this case, he bought the shares back at 1,000 x $50, or $5,000, which means he makes a loss of $4,000.

If you think about it objectively, in the traditional ‘buy low, sell high’ scenario, the potential downside loss is limited by the share price. That is to say, shares can never fall below zero in value and thus, your losses are limited to your invested capital.

However, there is technically no limit to how high a share price can rise, so your potential profit is, in theory, limitless.

But the converse holds true for short selling – your profit, since it is now dependent on the fall in share price, is limited, although your potential loss is now technically limitless.

Of course, that is only in theory. In reality, a stock’s share price does not rise to infinity, nor do shares commonly fall to zero.

The example above is simplistic and illustrates the concept behind short selling.

In practice, the Singapore Exchange (SGX) works on a three-day delivery period, which means that shares bought will have to be paid for three days after the purchase date.

When someone on the SGX short sells a share through his broker, he has three days to ‘deliver’ the shares to the buyer.

However, because of this three-day delivery system, it means that the short seller will only be able to ‘cover’ his short sale if he buys the shares (referred to in industry parlance as ‘buying-in’ the shares) on the same day.

For example, if Tommy short sells 100 company A shares to James on Monday, he has to buy back the shares on the same day in order to deliver the shares to James on Thursday.

But that does not mean that Tommy absolutely must buy-in on Monday though. He has two other options:

Don’t Buy-In, Borrow

If Tommy doesn’t buy-in the shares on Monday, the SGX has a facility where a short seller has until Thursday to ‘borrow’ the shares from another investor or institution who already owns the shares, for a fee. In this way, the shares will be delivered to James by Thursday, and James now owes someone else 100 shares of company A. James now can choose to repay the shares at a future time.

Automatic Buy-In

However, if Tommy is unable to find a lender, the SGX – acting on behalf of Tommy – will buy the 100 shares off a ‘buy-in’ market (a separate market from the main board and Sesdaq). The price at which the shares are bought-in is determined by a number of factors, but it is higher than the share’s price on the main board or Sesdaq. The shares will then be delivered to James. The point to note here is that Tommy would not have any control over what price the shares are bought-in.

Both these options add additional risk. Even if Tommy manages to borrow the shares, the fall in share price has to offset the fee paid to the lender in order for Tommy to turn a profit. And if he is unable to find a lender, then the SGX will automatically settle his transaction, buying shares at a price point that Tommy cannot decide on.

The bottom line is that short-selling is a trading technique that institutions and retail investors can use to make money even when markets are falling. However, it is risky so investors should consider their options carefully before deciding to short sell.