Traders playbook: Short selling in the spotlight

First, understand the dynamics involved in ‘shorting’ a stock. At its most simplistic it’s like short selling gold or S&P 500 futures - you expect the price to fall, so you sell to open a position, the price drops and you buyback for a profit. Or, conversely, the price rallies and you buy back higher for a loss. In the equity world, the process of shorting a stock involves borrowing the stock from a broker and selling it into the market to open a position. There's a cost involved to do this. The harder it's to borrow from the street the more expensive it will be.

Brokers source ‘borrow’ from many channels, hedge funds, pension funds, investment banks, for example. When they have the stock to lend, upon request a trader borrows the stock and sells them ‘short’ into the market, where there's naturally a buyer on the other side. If that buyer has the necessary agreement with their broker and they anticipate holding for a duration, that broker can then on-lend the clients stock out to the street and to another player who may then short the stock. And so, the process continues until we have short interest over 100% of the total equity float, which has been well documented of late and targeted through the likes of GameStop and several other names.

The use of short selling in the markets

Most of the focus has been on the funds that short sell as part of a longer-term thematic idea. They typically identify businesses with structural flaws, accounting irregularities or leveraged to a changing behavioural backdrop that will erode their earnings power. These activist funds would take out short positions in the identified name, write compelling research that gets passed around the trading floors, which to those who shared the view would act upon it, with stock prices potentially being driven lower.

Some would argue that they would use unscrupulous practices to get heightened levels of PR, spreading misleading and false information on the company, often leading to legal challenges. This model is now clearly challenged because r/WSB will now go after them as soon as they reveal their hand and one thing is clear, who wants to be short now in a firm with extreme levels of short interest? It’s just not prudent. The Tesla case study was perhaps the real inspiration here.

Hedge fund de-grossing is the real story here

The aspect which is being overlooked that's of interest to all active traders, regardless of asset class and who may not be watching Reddit is the long and short hedge fund model. While there are many types of hedge funds, with different objectives and varying degrees of leverage, it's important to understand their role here.

Many take a long exposure in a stock and subsequently offset (or hedge) this with a corresponding short position - this will reduce their beta to broad market fluctuations and subsequently turns the trade one of relative value exposure. In essence, the fund is looking for outperformance from one position against another – the essence of the hedge fund model. Both positions (or ‘legs’) may fall, but the fund hopes its short leg falls by more and vice versa and they net the difference. In an ideal world, the short leg falls, and the long leg rises.

By adding the long and the short exposure together this is called the ‘gross exposure’, and right now total hedge fund gross exposure is near record highs.

Consider that because of recent actions, hedge funds are reducing their short positions aggressively, especially to those names with high short interest and that the public is familiar with. Subsequently to rebalance, they close or reduce the long leg of the trade – this is key. This de-grossing of hedge fund exposure is impacting broad financial markets, in fact, last week we saw one of the biggest de-grossing of hedge fund exposures since 2009 and this is causing huge increases in broad market volatility, with the USD outperforming and funds scrambling for portfolio protection.

The somewhat ironic issue here being the fact that equity markets have been incredibly frothy, with extreme valuations, elevated margin debt (as a percentage of equity market cap) and stretched internals and subsequently many have called for a correction in financial markets. China withdrawing liquidity is a key factor, but no one anticipated it would come from the partial closing of short positions from hedge funds.

Whether you’re trading equity, equity indices, FX, or commodities, this must be a consideration as the long and short industry is a behemoth. If they’re compelled/forced to further close their short positions then they will sell out of longs too and this here is the linkage between a handful of illiquid, high short interest names and the global markets.

The role of short selling

The fact is through this process of lending out stock to another entity we see improved liquidity in the market and liquidity is a good thing - well at least for those not wanting to cause a short squeeze in single stocks names. For most, liquidity allows the ease of entering and exiting a position. It has a direct effect on trading costs in all asset classes and markets just function more efficiently. It allows two-way opportunity and traditionally institutional funds would reduce shorts aggressively when they sensed the stocks had reached a ‘value’ level and anticipated buying flow.

Short selling allows for price discovery and while we may see regulatory changes, as it stands, it’s the only way market participants can make a play on price falling. In a sense, it’s the last bastion of ‘free’ markets. By targeting a short position, it’s causing tremors through markets, resulting in higher vol and a de-risking. The irony of the situation is that it makes me want to short companies with quality fundamentals for 5-10% downside and not those with a poor business model, deteriorating balance sheet and high leverage.

Understand how to trade CFDs and the ability to short stocks with Pepperstone.