Significant equity market trading disruptions have recently occurred as a result of shorting stocks. Today, we take a close look at the topic of shorting stocks; specifically, what is trading short, who and why would someone want to trade a stock short, how does it occur and what are the related risks?
‘Short stock selling’ is a bearish strategy in which an investor borrows shares of a stock and then sells those shares with the anticipation of a profit by buying the stock in the future at a lower price. A ‘short squeeze’ occurs when a stock price moves sharply higher, and traders rush to limit their losses with share purchases to offset a previous short. A general equity market rally, favorable company specific news, or just plain speculation may be the reason for an upward move before the short squeeze.
GameStop, AMC Entertainment, and BlackBerry are examples of stocks recently associated with such speculation. Reddit and its forum Wall Street Bets, a social platform that discusses favorable/unfavorable stocks, is being linked to the recent fever pitch to short the aforementioned stocks. Trading platforms like Robinhood, an investing platform for small investors, placed many of the individual stock purchases resulting in a short squeeze. Most likely, significant institutional money through hedge fund trading accentuated the price moves.
What kind of share price volatility might we see with a shorted stock where traders are squeezed to cover their trading positions?
In theory, an individual has unlimited loss potential with shorting a stock. Unlike owning a stock in which your loss is limited to your original purchase cost, a stock has no upward boundary on price. Short-term individual prices at times can be unrelated to the reality of fundamental value. You may be forced to cover a short position at just the wrong time, at a price much worse than your trading plan. Since the investor borrowed the stock in a margin account (uses debt leverage), large moves in price may force a brokerage firm to close out an investors position if he is unable to provide additional collateral. If a brokerage firm is overexposed to clients unable to cover the cost of trades, then disruptions in the general market activity are likely.
Why is shorting securities allowed? During the financial crisis between 2007 and 2009, regulators banned short selling temporarily in response to the large drops in the stock market. Price discovery is one reason. Though it may not appear so, during a period of excess monetary liquidity and robust enthusiasm for equity investing, short sellers put negative pressure on unrealistic values of a security. Secondly, short selling may allow for early detection of fraud. Jim Chanos, a notable active short seller, was early to the discovery of the Enron fraud due to the profit incentive of company specific stock research.
Does TCF Wealth sell short in client portfolios? No, short selling is a short-term speculative trading strategy. TCF structures portfolios for the long-term, with asset class and security selection to match client expectations for return and risk. If you have any questions regarding this topic, please consult your TCF portfolio manager.
Glen C. Matz
VP, Portfolio Manager
Glen Matz is a Vice President and Portfolio Manager for TCF Wealth. He is responsible for portfolio management and security selection for client accounts and managed investment portfolios. Glen has been with TCF for over 14 years and has over 30 years of experience in the areas of finance including securities management. He holds a Bachelor of Arts degree in Accounting from Ferris State University and an MBA from Central Michigan University. His office is located in St. Joseph, Michigan.
This publication does not constitute legal, accounting or other professional advice. Although it is intended to be accurate, neither the publisher nor any other party assumes liability for loss or damage due to reliance on this material.
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