Last week I covered the potential impact on St James’s Place (SJP) shares if their stock left the FTSE100 index. I also mentioned the potential impact that short sellers have on the stock because a declining share price is fodder for them.
Short selling is where investors bet on a share price falling and profit if it then does so. Shorting takes many forms, but here is a typical example.
An investor wanting to short a stock might do so because they have seen a weakness in a company which isn’t evidenced in its share price. They ‘go short’ that stock and then issue a research note to the market which shows their thoughts/analysis. The market sees this and reacts. That is called a short attack.
Negative news comes in many forms, and, if persistent, managers may be inclined to leave the stock alone or disinvest. I don’t think SJP is on the receiving end of a short attack, as yet. Its products had high charges, and so the model was very profitable for a shareholder, hence it was held by those who didn’t really look for any trouble beyond the profitability.
Short selling has advantages and disadvantages. If a short seller sees a share is overvalued, selling it short (betting it will fall), can stop bubbles occurring and can keep prices efficient.
They also target companies with irregularities, weak fundamentals, questionable practises, or hyped valuations. All of this is good to maintain efficiency in market prices. It’s great for focusing the minds of management and ensuring they keep their organisation ship shape.
Risks can occur too with manipulation of a share price by spreading rumours to drive the price up or down. ‘Pump and dump’ schemes are known for spreading false upward hype regarding a share or investment, and then opening a short position at the top of the market. These are common and the biggest source of my ‘long sigh’ pub conversations.
On the upside, regulatory frameworks focus on balancing out these risks to ensure short selling contributes healthily to markets. Regulators may place a ban or restriction on shorting a share during times of market stress.
‘Short squeezes’ are where a shorted share rises rapidly, and short sellers are forced to buy back the actual share they had sold at higher prices to cover off their positions, which of course puts further upward pressure on the share and loses the short seller even more money – the ultimate negative feedback loop.
In 2021, there was a GameStop short squeeze where many small investors on the Reddit forum WallStreetBets collectively bought heavily shorted shares squeezing their prices upwards. This forced institutional short sellers to cover their positions and sell at significant losses.
In 2008, VW shares had a similar fate when Porsche announced it had acquired substantial VW shares. This meant there was a shortage of shares for short sellers to cover their positions. The price rocketed and short sellers took a beating.
Short sellers can also take a bigger beating. They might have used a Contract For Difference (CFD) to short the stock. A CFD is a complex instrument which also allows the investor to ‘buy on margin’ ie using borrowed money to stump up only a small amount required.
It’s a full column to explain this, but to simplify, the short seller can benefit from a multiple of each percentage fall. They must be very confident the share they are shorting will actually fall because every movement in the other direction can quickly magnify their losses.
A share shorted using borrowed money could continue to rise and the losses could become unlimited, way in excess of the actual amount invested. Therefore, there has to be significant confidence in the potential downside for a company which is not widely recognised by the general market. I may ask where that knowledge comes from, of course.
You can therefore see why the WallStreetBet crew above had great fun at the expense of the short sellers who some may say are profiteers of doom - winning because someone is losing.
- Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a financial or investment query call 028 68632692.
