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Understanding short selling

Readers that follow global markets might have come across the GameStop saga. Piggy has also written about this fascinating story.

Piggy’s Trading & Investing Tips
Batanai matsika

It is really about the “power and madness of crowds” as retail online traders banded against Hedge Funds that were “shorting” GameStop Corp shares.

At the centre of the saga, is a trading strategy or concept called “short selling”. This is when an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender.

Basically, short sellers will be betting that the stock they sell will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender. The difference between the sell price and the buy price is the profit.

Risk involved

Piggy notes that short selling involves amplified risk. When an investor buys a stock (or goes long), they stand to lose only the money that they have invested.

Thus, if the investor bought one Delta share at US$1,25, the maximum they could lose is US$1,25 because the stock cannot drop to less than US$0.

However, when an investor short sells, they can theoretically lose an infinite amount of money because a stock’s price can keep rising forever. As in this example, if an investor had a short position in Delta and the price rose to US$10 before the investor exited, the investor would lose US$8,75 per share.

Short selling permitted?

Several countries (including Zimbabwe) are hostile toward short-selling as it exposes many investors to massive losses. In addition, most institutional investors have much more advanced information access, financial power and trading techniques.

This means that even when allowed to sell short, retail investors will not face a “level playing field”. This is a foundational aspect in the regulation of capital markets. That said, short selling is common practice on the global foreign exchange markets. This takes us to an interesting case-study about George Soros.

It is recorded that Soros made approximately US$1,5 billion in just a single month (September 1992) by betting the British pound and several other European currencies that were priced too richly against the German deutsche mark.

Shorting a currency can be done in different ways. The simplest is to borrow money, say, Italian lire, and convert the borrowed money into, say, deutsche marks at the fixed rates. Then you wait for the lira to drop sharply against the DM, buy in the now cheaper lira to repay your debt and pocket a lot of extra deutsche marks.

Soros had been antincipating a financial turmoil in Europe ever since the Berlin Wall collapsed in November 1989, leading to the reunification of Germany. He expected the following: the breakdown of the ERM (Exchange Rate Mechanism) and a substantial realignment of European currencies, a dramatic drop in European interest rates and a decline for European stock markets.

In carrying out this operation, Soros sold short sterling to the tune of about US$7 billion, bought the mark to the tune of US$6 billion and, to a lesser extent, bought the French franc.

As a parallel play, he bought as much as US$500 million worth of British stocks, figuring that equities often rise after a currency devalues. Soros also went long German and French bonds, while shorting those countries’ equities.

Because of his strong credit, Soros was able to maintain all these positions with just US$1 billion in collateral.

Here is how his leveraged positions worked out: The pound dropped 10%, the mark and franc both rose roughly 7%, the London stock market gained 7%, German and French bonds were up about 3% apiece, and the German and French stock markets briefly rallied, but basically remained flat.

Overall, while the George Soros story is interesting, when it comes to the stock market, several participants have advocated for banning the practice of shorting. The following are some of the reasons that have been put forward:

  • Profiting from company failures is immoral;
  • The practice is damaging because it artificially lowers stock prices;
  • It is a privileged investment tactic that is not available to everyday investors; and
  • Short sellers manipulate the market, by conspiring.

Chapter 4 of the Investor 101 Handbook on Regulation & Taxation covers short selling. Download a copy of the Investor 101 Handbook from www.piggybankadvisor.com.

Matsika is the head of research at Morgan & Co, and Founder of piggybankadvisor.com. He can be reached on +263 78 358 4745 or batanai@morganzim.com/batanai@piggybankadvisor.com

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