It Pays to Take Note of Shorters

An article by ShareSoc member Michael Taylor

In light of the recent Burford Capital judgement that my friend Paul de Gruchy has written about in detail here, this has led to much debate about shorting, some of which I hope to add to here in this article.

Is shorting bad? Yes and no. It can be.

A broker who goes short on a stock then offers to conduct an equity placing for the same company in order to close their position is clearly blatant value destruction. Should a broker really be taking a position against its clients, and using its client base as a carrot in order to entice the company to raise some cash? Probably not.

Should individuals do that? Many traders close out their shorts in placings. It’s legal, and there is nothing to stop anyone from doing so. In my opinion there is nothing wrong with this – it’s a two-way market and if you’re able to bet on an asset going up by virtue of being long, you should be able to bet on it going down by taking a short position.

In my opinion, this is fair. Shorters can provide an obstacle to rampant bullishness. When bulletin boards are full of hundreds of posts a day, all claiming that the share is a sure thing to skyrocket (many of these are multi-ID handles, often conversing with each other), often shorters are the only dissenting voice to provide a balance. Unfortunately, that balance is often overwhelmed.

Positive feedback loops

When a share price rises, those who are long begin to believe they were correct, and because they were correct, this reinforces their belief in the stock. They spread the story to others, who see a rising price and assume the stock must be good. They buy in, and the spread continues – much like Coronavirus – as newly infected believers jump on board.

At some point, even the most stubborn of shorters can’t fight this pandemic – and only a fool would try to do so. Rather, it is best to wait for the blow off top and for punters to awaken from their drunken stupor, before fading the move.

Burford Capital and Muddy Waters

Burford Capital believe that many orders were ‘spoofs’ during the time when it was the subject of Muddy Waters’ bear raid. A bear raid is an orchestrated attack on a stock, designed to bring the price down.

Orchestrated may seem exaggerated, but if we look at the situation – Muddy Waters began to draw up interest by announcing that they were short of a London listed stock, and they would reveal the name at 08:00 the next morning. It’s all part of the promote, and promotion does affect stock prices more than many would like to admit.

Coming back to spoofs – a spoof order is an order designed to not be hit. This is annoying, as orders on the order book can vanish in the split second between me clicking place order on my platform and the order appearing on the orderbook. Should this be allowed? Spoofing was a result of defending against High Frequency Trading (HFT) – which front runs order flow.

My belief is that if an order is on the book – it should be a firm order.

What exactly is shorting?

Put simply, shorting is selling something you don’t own with the obligation of returning it back at a later date. How can you sell something you don’t own? Well, first the stock needs to be borrowed from somewhere in order to sell it.

To explain shorting a little better – imagine that I borrowed your mobile phone and sold it at the pawn shop for £100. Despite me selling it, I would still owe you the same mobile phone whenever you wished for it to be returned.

Fast forward a year, and your mobile phone manufacturer has churned out a new model en masse, and the price of your model has dropped 20% to £80. I decide to buy the mobile phone back, and return it to you – settling my obligation to give back what I had borrowed from you.

We can see how that through selling and buying back at a lower price I have pocketed £20 despite never owning the asset (the mobile phone) in the first place.

Now, let’s say that the new model turned out to be a complete flop as reliability issues were a huge problem, and everyone believed that the penultimate model (your model) was vastly better. If this belief then pushed the price to £150 I would still be obliged to return the mobile phone and so I would need to buy back what I had sold and return it – this time at a loss of £50.

But what if your model was scarce, and I had to pay £300 to buy the mobile back? That means I’m 200% in the hole! I only stood to gain £100 maximum, as the maximum any asset can fall is 100%, but I’ve now had to stump up several times what I owe to settle my obligation. I’ve lost more than what I originally bet.

Imagine that! Hypothetically, one’s losses when shorting are unlimited. But that really isn’t the case.

Due to new ESMA regulation, all retail spread bet accounts are protected by not being allowed to go into negative equity. There are tougher margin restrictions now, but when shorting in the UK, unless you’re listed as a professional, your maximum loss is 100%.

Why does shorting get a bad reputation?

This psychological fear of “unlimited losses” is partly to blame for the distrust toward short selling stocks. People say “I’m not a natural shorter”, and I get that people don’t feel comfortable, but I’m not a natural trader. I had to read lots of books, make my own mistakes, and put the time in required to be able to do what I do. Sadly, I wasn’t born a natural trader. I had to learn it – and anyone can.

Due to new 2018 ESMA regulation, spread betting companies do not allow negative equity and offer reduced leverage. This was necessary, as far too many were losing money hand over first and owing money due to not knowing what they were doing. The sad story of a young man taking his own life after racking up a $700,000 debt trading options on free trading app Robinhood (which sells order flow to HFT firms) shows that this clearly was the right decision.

Anyone can learn to short sell stocks – in essence you are literally betting on the underlying asset to go up or down. We’re looking at lines on a chart. It’s nothing more or less, and that’s all there is to it.

But what about simply taking the other side of the trade? If you like a business, you may go long of it. If you don’t like the business, and think it’s terrible, then you might be inclined to go short of it.

A market that bans any opposing views is not really a market at all.

Why is shorting good?

Shorting offers an alternative opinion. You might not like it, but a world where only one view prevails leads to one big groupthink. You may’ve seen it on bulletin boards, where opposing views are stamped out, and you may also have seen London listed CEOs call for a ban on shorting.

This is odd, because a business that can be affected by shorting is not a viable business – it’s a cash raising story-telling business. What’s the best way to raise cash? Create a good story and ramp it to high heaven. This pumps up valuations to levels way above their intrinsic value, and therein lies the opportunity for bears.

It makes little sense to go after a profitable and self-sustaining business, unless those very profits are dubious as in the case of Muddy Waters’ short attack on Burford Capital recently. An investor in a well-run business who has done their homework has nothing to worry about. Shorting brings balance to the market.

Why does shorting matter to investors?

I believe that investors would benefit from understanding the process of shorting stocks. There are several reasons for this. Firstly, shorting identifies low quality businesses. Whereas investors might find low quality businesses as a result of looking for high quality businesses, shorters actively seek out rubbish.

If you know the signs to look out for, for example, lack of profits being converted into cash, deteriorating revenue and margins, an increase in supply of the stock that has been suppressing the price, then it can help one be aware of the signs in their own investments. It’s certainly better to sell too early than to sell too late.

DISCLOSURE: At the time of writing, the author did not hold a position in Burford.