I have had many conversations with retail shareholders over the years, and one thing I've found is that a lot of people have little or no understanding of how short selling works. Pretty much everyone gets that its a ''bet'' that a share price is going to go down, and that short sellers make money when a stock drops. But ask people the mechanics of how a short sale works and often its deer in the headlights time.
Short selling is a big part of the market game. Not knowing how it works to me is like stepping onto a basketball court without knowing that you have to dribble the ball with one hand, and not two.
When explaining it to people I often use something removed from the market. If someone is wearing a nice watch I'll use that as an example. Let's say I have a friend who owns an expensive watch that sells for $5,000. But let's also say that I have learned that an announcement is about to be made that this same watch contains an element that has been proven to cause cancer. I know that once this news comes out, that my friend who is always bragging about his $5,000 watch...that he'd be lucky to get $5 for it.
So how might I profit in this made up example?
Simple. I borrow my friend's watch, maybe give him $100 to loan it to me for a couple weeks while I go on vacation. I then take his watch and sell it for the $5,000 it is currently worth. In a few days the news comes out, the metal on the backing of the watch has some coating that has been proven to cause cancer. I am then able to buy that same watch back for $5, if not the exact same one then another which is identical. I give my friend back his watch and have profited to the tune of $4,895 with something I never even owned.
That's exactly how it works in the stock market. But instead of a watch its done with shares.
I'll use the example of Nortel, a darling of many Canadian tech stock lovers in the 1990s. If memory serves it traded up around $180 at its highs, but for this example I will say its trading at $100.
Someone we'll call Mr. Bear is convinced that Nortel is a bloated pig at $100. He can go to a brokerage and ask to borrow shares of Nortel. Shareholders don't have physical possession of their actual shares, they're held in street name. Let's say there's a shareholder named Bob who is using a discount broker charging him $5 a trade. In his account sit 1,000 shares of Nortel, trading at $100 and worth $100,000 at current market prices.
The brokerage will lend the shares out, at a fee of course. Mr Bear then takes the 1,000 shares and sells them for $100 each, netting himself $100,000 from the trade. But of course Mr. Bear has to give those shares back at some point...unless Nortel declares bankruptcy and stops trading in which case he doesn't have to buy them back because they'd be worth $0.
Mr. Bear is counting on Nortel going down obviously. But remember I said Nortel traded as high as $180? This is where it gets fun.
When Mr. Bear sells the 1,000 shares he borrowed for $100 each he doesn't immediately get to take the money and run, the funds are held in a margin account. On top of that he'll be required to have extra money tied up in that margin account in case the PPS starts climbing. And if the PPS does start climbing the broker he owes will require him to put even more cash in his margin account. Let's say the margin requirement is 50%. After netting $100,000 from the sale of the 1,000 shares he needs to add in $50,000....if Nortel climbs to $200 per share he'll need to have $300,000 in the account.
This is where dreams of a short squeeze dance in the heads of longs. If the PPS climbs and Mr. Bear can't come up with the extra funds for his margin account then the broker will simply take the money in the account and use it to buy back the shares. Let's say Nortel goes to $200 and Mr. Bear comes up with the $300,000 to hold his position. But then it goes to $250 and the broker tells him to ante up another $100,000.....But Mr. Bear can't, he's tapped out. The broker then takes $250,000 out of the margin account and buys the shares back, In this hypothetical situation Mr. Bear just lost $150,000 large.
That is what longs dream of, but as happens with many dreams.....it rarely plays out that way.
Short sellers know the risks they're taking, and because of the enormous risk Bears are known to be hyper active when it comes to research. Do some searching on the Net about notorious hedge funds and you'll see stories about people going through trash bins to get the inside scoop.
That's why it dangerous to bet against 'Dah bears'. Never underestimate an opponent. That wisdom applies on the battlefield, in the sporting arena, and in the public markets. Longs would do well to check their egos at the door when seeing a stock they're holding having a large % of short interest.
Some short interest is to be expected with any stock, sometimes its hedge funds pushing a stock up and down, scalping for 1 or 2 points, maybe 5. But when you see a stock with 10, 20, 30% or more short interest....you might want to ask yourself, ''Do they maybe know something I don't''?
PPHM recently tanked, going from in and around $1 to about 30 cents in the wake of a cancelled phase III clinical trial. But just before it tanked news came out that shares of PPHM had triggered something called a ''Stop Loss'', which meant that so many shares had been sold short that few to none were available for further shorting.
For me that should have been a flag given what I know about short selling. But I was blinded by greed and dreamed of Bears overplaying their hands....a monster short squeeze had me envisioning big profits. Hindsight being 20/20 I realize the mistake I made. In my opinion what happened was obvious, word of the cancelled trial was leaked and smart Bears borrowed all they could until there was nothing left available for shorting.
That's enough for now....comments are always welcomed, just keep it polite. I realize this is very remedial for long time traders, but its something basic that many retailers don't grasp.
My next post is going to be a long idea, Hampton Roads Bankshares (HMPR) which as of April 29th 2016 had less than 3% of its shares shorted.
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