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Thursday, 9 March 2017
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The Anatomy of Shorting

WHAT IS SHORTING 

Each week ASIC publishes a list of stocks that have been “Sold short”. In basic terms it means stocks that have been sold by people who don’t own them.

It is not that easy to genuinely short a stock. You can do something similar through CFD accounts, but I wouldn’t deal with them, and nor would the big players, the hedge funds and the institutions.

Only some brokers offer the facility to set up a shorting account, because it is generally a time consuming, more risky activity for the same commission and the retail clients that tend to want to do it are generally more demanding of time and resources require more monitoring than a good old plodder.

To short something you have to contact a broker and ask how much stock is available to borrow. They contact the back office who contact one of the big share custodians. Australian custodians hold about three trillion dollar’s worth of stock which they are generally happy to lend out to brokers for a small fee, a fee that is, of course, passed onto the client. With that much idle stock around you can short most things although when there is a lot of action and volatility the stock that’s available to be borrowed can dry up and the smaller the stock the less the liquidity and the less stock will be available to borrow.

Once the broker tells you how much stock you can sell short you pick the amount and he’ll sell that borrowed stock for you. There is a lot more to the detail than that but that’s the bones of it.

When someone shorts a stock they do it in the belief that the share price is going to fall so they sell with the view to buying it back at a later date at a lower price, locking in a profit and returning the borrowed stock.

Of course sometimes a stock can move in the opposite direction to the shorter’s expectations i.e. it starts going up, and you may see those same people who shorted the stock scrambling back into the market to buy back the amount of stock they shorted to limit their losses as the share price goes higher. This is called “Short covering” and is often quoted as an excuse for why a share price is flying up after a recent sell down.

The ASX monitors shorting through its business rules which require all Member Firms (brokers) to tag any trade as a short trade if it is a short trade.

Most recently the global financial crisis caused shorting activity to run riot with some significant criticism that in an atmosphere of fear short selling was smashing share prices and undermining the integrity and confidence in the US and the global financial system. The US and Australia imposed a shorting ban in the GFC whilst they tried to stabilise the market sell off.

When they removed the shorting ban the list of stocks that were being shorted began to be published daily showing how much of a stock's trade related to shorting. The publishing of the list followed the outcry about shorting from regulators and investors alike and met the call for more transparency.

The shorting ban and the extra transparency was not popular with a lot of fund managers particularly "hedge fund" managers who made a business out of shorting stocks. Their annoyance makes it apparent that short selling information levels the playing field against them, which means it adds value to other investors.  

ASIC now publish the list which is in the Marcus Today newsletter on Wednesdays. It was designed “to provide better disclosure” but it is now a list that all investors and traders should keep in their peripheral vision because it highlights stocks that have an ‘issue’, are often highly traded, are often volatile and which can bounce sharply once the shorting ends. 

So how we can make money out of shorting or the shorting activity of others. Here are some basic observations:

  • http://www.marcustoday.com.au/webpages/images/report/20160304/yqdvyesg4765580320582073098.pngShorters tend to target individual, vulnerable stocks that have already started to drop. They rarely short stable stocks in steady uptrends. It’s like hyenas. They rarely do the initial damage but if they see a wounded animal they swoop in and ultimately they become the problem.
  • When big short positions appear (on the ASIC list) it can become self-fulfilling as people question why they are on the list, prompting fear, investigation and research.
  • When big short positions are open the stocks are more sensitive to news and likely to be more volatile (risky).
  • Good news in shorted stocks provokes rapid share price rises because of short covering and from the tables you might be able to identify those stocks prone to a big rise on good news, are prone to short covering rallies. Shorting is like an elastic band, the tighter it is stretched the quicker it will bounce back if the shorting stops.
  • Companies like ABC Learning, Babcock & Brown and Allco, and more recently Slater & Gordon have all at times blamed their share price falls on shorting. But almost all (in hindsight) appear to have deserved their share price falls and as one commentator said…”The only thing the short sellers were guilty of was not selling them a bit harder”.

http://www.marcustoday.com.au/webpages/images/report/20160304/image5558329853652439430.jpg

Ultimately for “investors”…short selling is a bit of a distraction, because it is generally a short term thing. But it is something you can also keep an eye on even as an investor, just in case one of your holdings suddenly becomes the victim. More likely than not (as with Slater & Gordon, ABC Learning, Allco and Babcock & Brown) it will be for a reason and the short selling disclosures highlight the need for you to do your work or get out of the way.

HOW TO READ THE MOST SHORTED STOCKS TABLE

Every week we put up the table of short sold stocks. I get regular emails asking “How do I use the shorting list”. This week let’s look at the list of most shorted stocks and shorting in general.

The list of short sold stocks is intriguing because it is a list of stocks that, apparently, people don’t like. When 80% of broker research is geared to telling you about the stocks they do like, often because they are paid to tell you that, it is refreshing to read a list of stocks someone doesn’t like. It is intuitively honest, where much of the research isn’t.

Here is the current table of the 30 most shorted stocks. The table shows the % of the stock sold short each trading day and the numbers go back 20 days which is about a month. If the number is pink the % sold short has risen since the day before and if its gone blue it has fallen since the day before. So the colour change shows you the trend in shorting in that particular stock.

As an example, Aconex (ACX), has been progressively shorted up until the last couple of days when the short selling finally reduced from 17.3% to 16.8%. Same thing with Myer (MYR) – it has been increasingly shorted until the last two days. So you would naturally ask…is this a buy signal? Meanwhile WSA, ORE, TFC, SYR, VOC are still being progressively shorted day by day and DMP has been increasingly short sold for 16 days on the trot. That has certainly reflected in the share price.

The shorted stocks list was of tremendous interest in the GFC when stocks like ABC Learning and Babcock & Brown were being targeted by shorters (for good reason), because it highlighted those stocks, and come another big market sell off it will become a focus again. A bear market is a bull market for shorting and when only 2% of the ASX 200 stocks are going up there is less opportunity to make money in equities by just going long.

But since the GFC this list has become less useful because without the momentum of the GFC behind it I don't know that you can clearly translate the stocks on the list into money making trades on a reliable basis, and if you could, it would be on a pretty short term timeframe which is too stressful and random for most.

What the list does represent is a list of potentially good trading stocks. Just look at the stocks on the list. They are almost all “stocks of interest” to traders and that interest is heightened by the short position because when they announce something positive, short covering (having to buy the stock back in a rush) can potentially accentuate a rally, and when they announce something bad, well they’ve already been shorted.

So they tend to be 'stocks of most interest to traders' - cyclical stocks, risky stocks, volatile stocks, stocks that trade high volumes, stocks with big ‘issues’, stocks that could move a lot on little news. Stocks that will move on the cycle, on factors that can change quickly. Many of them have become so because they have had a "Big issue” – a profit warning, a collapse, a failure, or they are stocks that are highly geared to a commodity or cycle. Investors wouldn’t touch half of them but on one small change in the trend of their negative driver they could fly. So this list is a traders delight.  

Some stocks are permanently on the list because there is some institutional interest in shorting them - but that may be a long short fund with a position offset by a long position in another similar stock...it may not reflect negativity so much as relative negativity, relative to a 'paired stock'.

The bottom line is that I would use this list to identify stocks that are likely to be more volatile on results/announcements/news. On that basis the list is quite interesting, especially if you have a positive view, because any good news and they will presumably 'rally more'. But the list is also an alarm bell for investors, becaquse these stocks tend to be more volatile, unpredictable and therefore ‘risky’. If you are about to buy a stock and want to sleep at night stock, then just check it’s not on this list first.

 ANATOMY OF SHORTING

When the bear market was in full flight (during the GFC) there was a lot of shorting activity. A bear market is a bull market for shorting so of course it becomes more prevalent, and when only 2% of ASX 200 stocks are up in a year (2008) there is simply no opportunity to make money in equities by just going long. So everyone wanted to know about shorting.

So here is the pocket version of shorting – in a bull market this becomes less relevant.  

  • In a rising market the average trend is up which favours long only funds and shorting is understandably a small feature of the market because it is playing against the odds and the use of it negates other generally positive returns.
  • Shorting sounds clever but if stock markets generally go up it is not something you want to do all the time, just 'at times' and in particular stocks that have specific problems.
  • You may have heard of 'Long Short Funds'. These are funds that argue that you are only exploiting half the opportunity if you can only bet on rising prices. If you can bet on falling prices as well you have twice the opportunity. Nice idea but most long short funds fall into the trap of always having some short positions when the market is going up which it does most of the time and having long positions when the market is going down. The net effect is that the shorts detract from the performance of the longs in a bull market and the longs detract from the performance of the shorts in a bear market and the result is a fund that underperforms in all markets. Far better would be a fund that is either short or long, that calls and times the market instead of blurring their returns with both long and short positions all the time.
  • http://www.marcustoday.com.au/webpages/images/dynamic/tdtgynmk33582.jpg“Fear” is much easier to generate than optimism. Spreading fear is much easier and creates a lot more reaction in a shorter period of time. Fear is the weapon of shorters and their job is to take a position and then set about generating fear.
  • Fear can create radical share price falls whilst optimism tends to manifest itself slowly over a longer timeframe because it is hard to generate optimism whilst fear can appear in moments. Because of that stocks fall three times faster than they rise so shorting tends to happen in bursts. It is not about taking a long term negative view on a stock, a negative 'investment', it is more about preying on stocks for short periods.  
  • Once short many traders set about generating fear through well placed media articles and commentary (as they did last week with the Australian property market crash fears). When set short sellers do their best to perpetuate the fear.
  • There are a lot less shorters than long only investors and to generate an impact they have to focus on individual stocks rather than invest across the board. The game for everyone else is to identify where they are focusing their attention and get out. 
  • The ASIC list of shorting which we have been publishing weekly in Marcus Today (Wednesdays) is your best guide to picking up on the stocks in focus. The list shows the stocks that have seen the highest percentage of trades as short trades. The trend in shorting activity week to week is of most interest. Look for stocks that have rising short positions and for stocks that appear on the list for the first time.
  • There is a flaw in the reporting of shorts because although brokers have to declare if their client's trade is a short trade they don’t have to declare if it is a covering trade. So you only see the shorts. Not shorts being covered.
  • Although shorting is detrimental to equity market investors and hurts the majority in favour of the few the ASX appear unwilling to police it and even discourage it because they are conflicted. When a shorting ban was introduced in the GFC a lot of hedge funds, unable to short also stopped going long. They went to cash and stopped trading. That killed trading volumes, the lifeblood of the ASX. So there is scepticism about their simultaneous role as policeman and beneficiary.
  • Shorting is mostly done by institutions and not always just hedge funds. It is becoming an every day activity for many funds rather than a niche business for a few.
  • Private investors don’t have the sophistication or firepower to execute shorting selling strategies alone, they have to identify what the major players are doing and piggy back.
  • International institutions are more active than the domestic institutions.
  • Shorting is always better in packs. This has been the case since George Soros and his disciples took on the world’s currencies. Collusion between shorting fund managers pays although no-one will admit it and no-one will be able to prove that it goes on. 

Targets for shorting are stocks in which you can generate fear. That isn’t too hard in a bear market and the best targets are those companies with the following qualities:

  • Are already trending down or have had 'shock drops' already.
  • Weak balance sheets – high levels of debt.
  • Are in the middle of a "Strategic review" - they obviously have problems already.
  • Have lost their CEO or have a CEO with a large personal interest that acts in their own rather than shareholder interests.
  • Earnings uncertainty - Cyclical stocks are more prone to be targets than defensive stocks. Their earnings are less reliable and uncertainty easy to provoke.
  • Stocks that are hard to analyse - if earnings are predictable you can easily value a stock and it is much harder to spruik disaster.
  • Growth stocks on high PE’s. Much easier to provoke selling.
  • Generally the biggest shorting commodity is fear of debt which translates into a possibility that the stock could go bust. In the 2008 bear market it is was exposure to subprime, then the credit markets, then the economy. Last week it was the Australian property. Last month it was exposure to energy sector loans. Follow the themes. 

The shorting cycle:

  • Identify a stock on the above criteria, one that is highly vulnerable to the fear factor.
  • Borrow stock and sell it, putting the price under pressure.
  • Tell your mates.
  • Drop the odd innuendo about the balance sheet ('rumourtrage').
  • Hopefully the media picks up on the issues.
  • Analysts are prompted to look at the company by their dealers who are worried by the share price fall and the media stories.
  • Analysts highlight/re-emphasise the weaknesses rather than commentate on a stock's strengths (loss of the benefit of the doubt).
  • Long only investors jump out.
  • Institutions detect the trend and start selling.
  • The company is publicly bombarded with barbed questions from analysts and media.
  • The company starts to doubt themselves.
  • The company starts to squirm and issue pacifying announcements that simply highlight the issues.
  • Shareholders start pestering the company.
  • The company announce the death knell for all share prices - a "Strategic Review" - which means "we don't know what the problem is but are going to pay Price Waterhouse an enormous sum of money to do our job for us and tell us what we should already know". 
  • Pandora’s box opens on their debt structure, never a good thing - most companies have debt which is very manageable but when those structures are revealed investors are often horrified even though its normal.
  • The company addresses debt concerns by announcing a plan to cut the dividend, reduce capex (aka - stop investing in the business) and sell assets.
  • Failing that they announce a damaging deeply discounted accelerated rights issue on a share price that has already been carted out and is on multi year lows.
  • Immediately after the institutional part of the placement is completed the long only institutions tip the stock back out for a profit driving the stock back down to the placement price.
  • Retail investors are offered a the opportunity to invest $5000 at the placement price after all the institutions have already sold out, institutions that weren't necessarily shareholders before the placement.
  • Shorting funds often use the share issue to cover their shorts so a rights issue will sometimes end the “attack” marking a low for the price. 
  • But only sometimes....

The basic game is "Go short and then start spreading the word".

How to combat a short attack:

Announce you have no debt issues and are not going to have a rights issue. Get some fund managers to buy the stock. Get your tame brokers to re-issue their positive reports, sorry, independent research that you paid for when you paid them that large corporate fee last year. 
 

It ends up being a War of Words and if the company wins the rebound is fast as the short funds have to cover in the market in competition with each other. 

How to make money out of shorting…. 

Learn how to short and learn to identify the targeted stocks. 

Or…as a long only investor: 

  • Avoid buying the stocks that are being targeted. It is so tempting to catch the knife. To buy a stock that has fallen hard. Don't. Shorting is relentless. Most "Shock drops" start trends not end them (Slater & Gordon). Stocks rarely turn on a sixpence to suit you.
  • Sell the stocks that you hold if they get attacked. Don't hold onto your fundamental faith in the face of shorting....just sell and hope they get the share price down so you can buy it back. You will get chewed up by shorting if you adopt a head in the sand buy and hold or long term value approach based on faith. All very well but you will be tested in the short term (in the GFC RIO fell 54% in 9 days from 6560c to 2991c when BHP pulled its bid). You need to respect the herd sometimes, it can do some amazing things. When it turns on your stock you are better off chucking in your long term ambitions. Don't fight the shorters. You don't have to go short yourself but you can get out and take advantage of their selling to buy more stock after they have smashed it and started to cover. Buy into the first big bounce.
  • Look to buy shorting victims for long term value when they are smashed. If a company isn't going bust shorting creates some incredible opportunities (Elders). 

Bottom line – keep an eye on the shorting list we publish each week. If you are a long only investor watch out if your stocks appear repeatedly. If you are a shorter….jump on board and spread the bad news.

Other comments:

  • Shorting is within the law.
  • Shorting can make a mockery of long only value investment. It has no respect for value or stock market puritans.
  • The stock market is not about value it is about value and sentiment and at times sentiment holds more weight for longer than your intrinsic value calculation. In fact shorting can create issues that destroy value...factor that into an intrinsic value calculation.
  • Shorting is not long term it is short term.
  • Shorting creates a lot of volatility and volume and attracts daytraders….long only day traders beware…the trend is against you going long first. You have to sell first….which you can’t unless you are shorting. 
  • Shorting creates opportunity.

Beware buying the victims, beware catching the knife. Odds are firmly against you and when the shorters have their teeth in they rarely let go before the kill.

Here is a website that focuses on shorting - CLICK HERE


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