The Long View on Short Selling
In the wake of recent stock market volatility, the phrase “short-squeeze” has become front-page news and the topic of “short selling” is now kitchen table conversation.
For many, one question continues to stand out: how could market participants short sell over 100% of the outstanding shares of a company? That leads to a familiar debate — should short selling even be allowed?
It’s a complicated and nuanced topic, but one worth discussing as we continue our educational series about topics that have been in the news. Before we get into the weeds, we should first start with explaining what it means to “short a stock.”
What is Shorting?
Short selling is the practice of selling shares that you do not own. Under Securities and Exchange Commission rules, short sellers need to borrow shares from their broker before they sell short. Once the short seller is “short,” they hope that the price of the stock falls, and then they attempt to buy the shares back later at a lower price, for a profit. When the short position is closed the borrowed shares are returned to the broker. In actuality, short selling is a bit more complicated than this example, but this is the gist of the strategy.
For many, short selling is one of those strategies that, when explained, can lead to blank stares, raised eyebrows, and the typical question… “How can I sell shares of something I don’t actually own?” Most investors know the traditional mantra of “buy low, sell high.” The idea is straightforward — buy a stock to open a position, hope it climbs in price, and sell it for a profit, closing your position. Short selling is the same idea, but in reverse.
Is Short Selling Bad?
This is a topic that’s continually debated. Short sellers are scorned by many for attempting to profit from the demise of a company. Others argue that short sellers play a vital role in our markets by providing liquidity to buyers, hedging risk, and shining a light on potential corporate malfeasance. In reality, short sellers come in all shapes and sizes, each with different motivations.
Some short sellers are day traders looking to short stocks that have risen quickly intraday, hoping the stock will quickly revert to some lower short-term price average. It’s a quick trade and barely puts a dent in the long-term trajectory of a stock.
Another type of short seller is one looking to employ a “long/short” portfolio strategy. This is a more advanced approach to investing, with the idea being that some stocks go up, while others go down. The goal is to buy stocks that are seemingly “undervalued” and short stocks that are seemingly “overpriced” simultaneously. Then, the investor continually adjusts the “long” and “short” exposure of their portfolio based on market conditions.
And then, there are the big short sellers — the whales. These traders are few and far between, but gain notoriety because they make bold claims and big bets that a company is inherently rotten, and the price is set to fall, hopefully to $0. These short sellers seek to identify stocks that are overpriced, overvalued, and sometimes in the process expose fraudulent companies. Remember companies like WorldCom, Valeant Pharmaceuticals, and Enron? These companies became targets of short sellers for suspected fraud, and in these cases, the short sellers were right.
But short sellers can sometimes overplay their hand and get it wrong. Enter the “short squeeze.”
The Short Squeeze
Savvy traders keep an eye on the percentage of shares of a company being shorted, which is called the “short interest.” Short interest is a simple calculation: take the total number of shorted shares and divide them by the total shares outstanding. For example, a stock that has 10 million shares outstanding and 1 million shares shorted would have a short interest of 10%.
For some stocks, short interest can be quite low–in the single digits. In others, it can rise well above 100%, meaning more shares are being shorted than the outstanding shares available. (More on how this happens below). And when this happens traders take notice, and some attempt what is known as a “short squeeze.”
Essentially, the goal of a short squeeze is to drive the price of the stock up as high as possible, forcing short sellers to buy their stock back at a higher price than what they sold it for. If this is successful, the price of the stock can skyrocket in a short amount of time, causing a lot of pain for short sellers.
Why does this hurt short sellers? Because the price can theoretically go up forever. Remember the mantra, buy low, sell high, but in reverse? Well, selling low then buying higher is bad, sometimes, really bad.
Short Selling and the Impact of the T+2 Settlement Period
So, back to our original question–how could market participants short sell over 100% of the outstanding shares of a company? The answer is a bit technical, but one way has to do with a combination of how short sales are arranged combined with how stock trades are processed, or “settled.” Let’s walk through it step by step, starting with an investor that owns the underlying stock in question.
To get a higher rate of return on their investment, sometimes an owner of a stock lets their broker lend out their shares at interest–a process called stock lending. (Robinhood lends out customer marginable securities, which is a standard industry practice.) Meanwhile, a short seller, through their broker, must first borrow a stock or determine that it can be borrowed before selling shares short. However, there are certain exceptions to that rule.
Some stocks are on an “Easy to Borrow” list; meaning investors can execute a short sale and their broker does not specifically have to locate or contact the source of the shares that are being shorted, because the assumption is that the stock will be located. And there are also “Hard to Borrow” stocks. These stocks are difficult, or unavailable, to borrow, which means brokers have to take additional steps to ensure that the stock is available before a short seller can execute their trade.
Once a short sale is arranged and executed, borrowers are subject to the standard stock settlement period, or “T+2.” (More on the risks involved with the T+2 settlement period are discussed
here). This means their broker has two days to deliver the shares to the buyer. If, for whatever reason, the shares are not delivered within the two-day settlement window, this is called a “fail to deliver.” The “fail to deliver” leaves the short seller “naked,” or unable to deliver the shares to the buyer. If the shares cannot be delivered after a certain period of time, the broker must buy the shares back.
And because of T+2, shares can sometimes be sold short continually, resulting in more shares being shorted than are technically available. See, once the shares are sold, someone on the other side of that transaction has bought them. And in turn, if they allow their broker, the same shares can be lent out to another short seller, and on, and on (and on). Although the SEC has banned outright naked short selling, it is this two-day latency for delivering shares (which, in turn can be lent out) that can play a large role in short interest percentage being higher than 100% of shares outstanding.
Final Thoughts
Even though the brokerage industry continues to evolve, there are still existing processes and legacy technology that can contribute to a scenario like we’ve explained. Real-time stock settlement could help in a number of ways, including to curb naked short selling by keeping an air-tight account on who owns what, when, and where.
The market mechanisms behind short selling, securities lending, and clearing are complex. This complexity can lead to the perception that the game is rigged to benefit certain market participants at the expense of others. Although this isn’t necessarily the case, abuses do happen and at a minimum perception can become reality for some.
In closing, we believe education is paramount and that it’s our responsibility to continually shine light on and demystify the complicated nuances of the financial industry — that’s one of the reasons Robinhood was founded. We also believe that moving the industry towards a real-time stock settlement can help play a role in curbing excess short selling, while bringing more transparency and stability to the markets.
Michael Obucina is Options Analyst and Education Lead at Robinhood Financial.