The first time I watched The Big Short, I came away knowing less about finance than I did walking in.

That’s not exactly true, but I became all too aware of everything I didn’t know about the forces orchestrating our lives. Like many, I believed the world of finance was as inaccessible and impenetrable to an outsider as a physician’s trade journal.

But although the 2008 subprime mortgage crisis, the most emphatic example of shorting in recent memory, is not an easy event to explain, the truth is shorting goes on every day and anyone can do it, even you.

When you normally buy shares in a company, you’re betting the price is going up and that you’ll eventually be able to sell at a profit. But the market isn’t just for those with sunny dispositions: there are ways to bet something is going down as well.

Shorting is essentially a bet. In the movie, Christian Bale’s character, Michael Burry, bet against the housing market after his research pointed to its collapse.

Burry used a more complex financial instrument to do so, but the relative theory is the same for small-timers like us. After all, you can’t just walk up to your broker and say “one short on the housing market, please.”

But you may be surprised how much of the market is accessible for retail investors. Hell, you can speculate on agriculture prices through wheat futures. There is a tradeable security for almost everything.

But the housing market was shorted through mortgage-backed securities. Banks began offering (bad) mortgages as a packaged investment and Burry knew many of them were going to fail. So, he bought all the credit default swaps he could as insurance. When they failed, he stood to benefit.

This is just one example of how shorting works, but we’ll use another example so you can follow along in real time.

Typically, short sellers approach a broker and ask to short a company. The broker then lends X amount of that company’s shares to the short seller, who sells them immediately. Either way, the short seller eventually has to buy the same amount of shares back and return them to the broker, but the outcome, how much money is made or lost, depends on which direction the stock moves.

If the share price drops, you’re in the money. The broker’s shares can be repurchased for less than they were sold, and the money left over is yours to keep. If the price goes up, the shares still have to be repurchased but you end up paying the difference.

Herein lies one of the greatest dangers of shorting: your potential gains are capped at 100% but your losses are unlimited.

It’s important to know that it’s you against the broker. They are not your friend and have no interest in your short turning out. And if the short interest is high, your broker will charge you higher interest for the “privilege” of shorting that company.

Short interest

Tesla (TSLA.Q) is currently trading at USD$213.99 and the company has a short interest rate above 30% as of July 29, 2019. This means 28.53% of a company’s shares currently in circulation have been sold as shorts, or are being used as bets that the company’s share price will fall.

For comparison, Nike (NKE.NYSE), a company we discussed in another entry in our educational series, only has a short interest rate of 0.67%. This means an insignificant number of investors believe the company’s stock is going to suffer in the near term.

Short interest affects investors and companies differently. Investors trying to short Tesla will find their brokers charging them a premium to “borrow” shares. Higher demand means higher cost.

Although short interest has no effect on Tesla’s day-to-day operations, high short interest may be symptomatic of a perceived flaw within the company’s business model or management which would naturally affect confidence from investors and banks alike.

But we’re not worried if Elon Musk can get the money he needs, although that would be useful information for your short position. We want to know about shorting from the investor’s perspective.

That’s why due diligence is so crucial before making a risky investment decision. Due diligence is just a term for research on a company.

But finding fraud or mistakes in a company’s financial statements is incredibly rare. These outfits employ high-calibre accountants who know how to report figures in a compliant, if not accurate, manner.

And so short selling outfits like Citron Research publish reports about companies they feel are overvalued using other methods. If a cannabis company says they have a dispensary in Bermuda, a short-selling publication might fly down there and take pictures to see if it lives up to the press releases and the valuation the owner said it had.

Here at equity.guru, we use old-school, hard-charging journalism to find holes in a company’s assertions as a way of steering unknowing investors away from bad investments. The difference is we don’t short.

And we don’t do put options either. Put options are similar to shorting, but different.

Courtesy of Giphy

To explain put options, we must first understand another concept: underlying value. The underlying value of a stock is the company it belongs to. That stock is just a constellation of pixels on your screen, but it represents ownership of a company and its assets.

Land, property, equipment and more. That share is a voucher for ownership in that company and its assets. But you can’t trade 1/1000th of a company’s tractors, and even if you could they most likely need it to continue operating.

And so in the same way the share represents a tradeable stake in a company, an option is a tradeable voucher for shares. It’s a way of making money on a price swing similar to shorting, but less risky.

Here is a scenario to better illustrate this concept. Company X is trading at $12 per share and you buy one put option on Company X’s stock at $10. The option itself doesn’t cost $10, it could cost $0.20, but it’s a voucher which would allow you to sell stock at $10 before the option expires, irrespective of the current stock price.

You may be thinking, ‘but why would I want to sell shares $2 below market pricing?’ It doesn’t make sense now, but if Company X’s stock goes to $7, then you’re able to sell it $3 higher than traders who didn’t buy that option.

But wait, there’s more. You could trade the option. Since the option is also a security, its value changes as well. If Company X’s stock falls below $10, the option could now be worth $2 instead of $0.20. Trading options instead of cashing them in is sometimes more profitable than the inverse, but options have expiry dates, unlike shares. They’re also less liquid, and selling them isn’t as instantaneous.

It’s their volatility, the wild swings in price, which makes them attractive to traders like you.

–Ethan Reyes

 

 

Written By:

Ethan Reyes

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