Defending Your Shorts!

By David Romoff

Risks & Rewards, September 2021

How risky is shorting?

How is it possible for there to be more shares sold short than long shares?

Why might your broker be unwilling or unable to sell you shares?

What if your fund is shorting Gamestop and Wall Street Bets discovers the fund’s position?

Let’s explore this from a risk manager’s point of view.

Navigating out of a Short Position That is no Longer Desired

Imagine that you are a risk manager at a major hedge fund. Your traders are shorting a large portion of a publicly traded company. Traders from other companies have found you out and are onto your plans! Social media lights up as it has identified your fund as a culprit in shorting a beloved company. The stock price of the company starts rising fast as its supporters buy up shares. What do you do to get out of this position?

Here is what you do:

• Buy calls that are out of the money but at a price that will be crossed.
• If you want to buy the calls for free, raise some money by selling puts at the money.
• Start buying back the shares you sold short.
• Repeat the above steps until your short position is closed.
• As you approach buying back all the shares sold short, start buying back your puts.

That's it, you're out.

The Story of ABC Company and how to end up With More Than 100 Percent in Short Positions 

Now consider the following hypothetical scenario:

• You think the stock of ABC Software Company is way overpriced.
• ABC’s products are not selling.
• Competitor software companies are far outperforming ABC.
• And the CEO of ABC was arrested after roaming the streets at night claiming to be Batman.

So you decide to help humanity and yourself by shorting ABC stock in order to make the market reflect the reality that money invested in ABC Company is better spent elsewhere. You go to your brokerage and ask to borrow shares in ABC Company, and your broker has good news to share regarding your request. Another customer at the brokerage recently filled out paperwork that allows their shares in ABC Company to be loaned out. 

You borrow some shares of ABC from that customer, keeping in mind that you will be required to give them back at some point. In the meanwhile, you sell the shares you borrowed.

Your sale of the borrowed ABC shares puts downward pressure on ABC’s stock price. The result is a kind of self-fulfilling prophecy. But keep in mind that when you buy back the borrowed ABC shares to return them to the lender, you’ll be driving ABC’s stock price back up. In this way there is a cosmic fairness in the market’s reactions to your actions.

Now you wait for the world to discover that ABC company is in trouble. When that happens, you will buy the stock at a cheaper price and return it. Everything will be right in the universe and your bank account.

But now consider what you previously thought what was unthinkable: ABC’s stock price doesn’t move!

And a few weeks later, there’s more breaking news on the company. ABC’s CEO is at it again, and this time he was arrested after roaming the streets dressed as a vampire.

Yet ABC’s stock price remains steady! You ask yourself repeatedly, “Why doesn’t the stock fall?” You cannot figure it out. Every piece of evidence tells you it should.

Therefore, you double down on your strategy, and decide to short ABC stock again. You borrow more shares of ABC stock and immediately sell them again.  

This time, something interesting happens after you sell the shares you borrowed that you will never know occurred. The new owner of the shares you just sold lends those shares to someone else who has the same view as you do about ABC and wants to short the company’s stock. By chance, these exact shares have now been loaned out twice. And for each of these shares that actually exists in someone’s possession, two are short. If this occurs with great frequency, the result is that more than 100 percent of ABC company shares have been shorted. 

How will this all play out? Let us consider two possible scenarios, with the second scenario building on the first.

Coda 1: The Shorts 

Now the story takes a completely unexpected turn. The ABC Software Company that you have been shorting publishes a press release announcing an exciting new business development. It turns out that a leading Hollywood movie studio has offered to pay them hundreds of millions of dollars to do the special effects for their upcoming movie and video game franchises called Batman and Morpheus the Vampire. It turns out the CEO at ABC is not so crazy after all! His nocturnal meanderings were part of a gorilla marketing campaign! The market reacts excitedly to the news and sends the company’s stock price soaring!

Investors race to their brokerages to buy shares in ABC. Your broker, Sherwood Forest Brokerage LLC, has a major problem: customers like you are going to be unable to afford to buy back all the shares you have shorted. The brokerage needs those shares in order to be able to sell shares to new customers eager to invest in ABC Company. Because they are afraid that you will not deliver the shares that you have sold short, they temporarily suspend selling shares in ABC. And now Sherwood’s customers are furious with the broker because they cannot get in on this rising stock.

Coda 2: The Longs

Now the story takes one more unexpected twist. The stock price of ABC is soaring, and customers are trying to buy as much of it as they can. Suddenly the movie scripts for the Batman and Morpheus movies are leaked to several leading comic book movie critics on YouTube such as New Rockstars and The Cosmic Wonder. They weigh in with fresh video analysis panning the stories. Posts on social media say the stories are worse than The Last Jedi and Justice League combined. ABC’s stock price falls to the ground and customers who have been borrowing from brokerages like Sherwood Forest on margin now owe a lot on their ABC purchase and have little value to show for it. As a result, these customers might not be able to pay for the borrowed shares. To protect itself from this type of loss, Sherwood Forest increases the margin requirement. In response, some of the minority of investors who like the Batman and Morpheus movie scripts are furious. They say that Sherwood Forest Brokerage is protecting those with short positions in ABC. 

What do you think? Is short selling as risky as commonly believed, or are the market dynamics simulated above mitigations for this side of the market? Let me know your thoughts!

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.

David Romoff, MS, MBA, is associate director and lecturer in the Enterprise Risk Management program in the School of Professional Studies at Columbia University. He can be reached at djr2132@columbia.edu.