What’s Going On?
In all honesty, last week, I wanted to write about the latest hot topic on Wall Street which was the short squeeze perpetuated by some traders gathered on the website Reddit who traded primarily though a popular small investor trading site called Robinhood. However, I was all too busy fielding phone calls, emails and texts from clients and friends who asked me what was going on. I also spent some time helping take care of our new grand puppy.
For a good portion of my career at Merrill Lynch and prior to that at other Wall Street firms, I was heavily exposed to the inner workings of short selling, stock lending and hedge fund operations. If you just say “Long Term Capital” to me I will convulse into my own form of Tourette Syndrome after which I will be kind enough to give you an insider’s account of what went on with the group from When Genius Failed.
To understand what took place last week, first you need a primer on short selling. Back on October 8, 2007 I wrote a guide to short selling for The Street.com, titled How Short Selling Works. That article is no longer available online, but I kept my own copy and notes from which I will now use as the basis for today’s MGF commentary.
Short selling is often looked at as a nefarious aspect of trading and investing. However, it is quite legal, serves a necessary function in the securities markets and can be a valuable tool for an investor or trader — whether on an individual or professional level.
Short selling provides investors with the ability to profit from the decline in a stock’s price, hedge positions or portfolios, manage taxes and create arbitrage positions. Since short selling is complex and operates outside of the purview of many investors, short selling is highly misunderstood.
I will begin by laying out the mechanics behind the short selling process, the account requirements and the federal regulations that govern the transaction.
What Is Short Selling?
Short selling in its most basic form is when an investor takes a stance that a security will decline in value. In doing so, the short seller will sell stock that they do not own. This transaction will trigger a series of processes that ensure that the sale of this stock can take place.
The Short Sale Processes
Every short sale can involve up to four different parties which have a role in the transaction. Here are the functions that each player has in the process:
The transaction (known as a “short sale”) is initiated by an individual or organization (known as a “short seller”), who desires to “short” a stock. Once the stock is sold short, the short seller must deliver the stock to the buyer. The buyer cannot differentiate whether the seller is a short seller or a long seller of stock — nor do they care. The buyer is only interested in receiving the stock they have paid for. The short seller has a problem though. He or she does not own the stock sold to the buyer. Hence, the short seller must borrow the stock to be able to deliver it to the buyer. How?
The short seller will utilize a broker to arrange to borrow the stock from a stock lender to be used to satisfy the short seller’s sale of stock to the buyer. This transaction takes place in a margin account and might have other economic consequences, which I will discuss later.
Please note that in some instances, the selling broker may in fact be the stock lender while in other circumstances, the selling broker must borrow stock from a third-party securities lender.
When the buyer receives the stock and pays for it, he or she is satisfied and no longer has any involvement in the transaction. The other three parties (the short seller, selling broker and stock lender) are still linked together by the stock loan.
In 2007, just before the global markets collapsed from the financial crisis, the SEC eliminated the “Uptick Rule.” The Uptick rule was established after the 1929 Stock Market Crash to prevent bear raids on stocks. Removal of the rule, in the opinion of James Cramer (of CNBC and TheStreet.com), William Furber, Eric Oberg and myself was dangerous for the markets and together we sponsored a letter to the SEC to reinstate the rule. It fell on deaf ears.
Stock Borrow / Loan
Since the stock lender has lent out securities, it will require that the borrower (the short seller) post collateral to secure the loan. This collateral is derived from the short sale proceeds, which the short seller receives from the buyer. However, the selling broker will receive the cash from the buyer and will not disburse it to the seller. Instead, the selling broker will withhold those short sale proceeds, make a “memo entry” in the short seller’s account and then use the short sale proceeds to post as collateral against the stock that was borrowed from the stock lender.
As the short seller has sold stock but not received cash, he or she will miss out on the ability to reinvest the sale proceeds that are now in the hands of the stock lender. The stock lender appears to get a free lunch from this transaction by benefiting from the reinvestment of the sale proceeds. If you are an individual investor, then this is indeed the case. However, if you are an institutional investor, such as a hedge fund or pension plan, then this inequality is cured by the stock lender paying a rebate to the selling broker.
The rebate represents a sharing arrangement on the interest that the stock lender earns on the collateral, which it holds. For example, if the stock lender earns 3.5% on the cash it holds, it might pay the short seller 3.0%.
Furthermore, institutional short sellers may have to pay a fee instead of receiving a rebate on stocks that are hard to borrow (in other words, stocks that are in limited supply with large short seller demand). As an example, AMC Entertainment (AMC) may be a stock which is heavily shorted with a limited amount of stock that can be borrowed. So, an institutional borrower of AMC might have to pay a fee of 10% instead of receiving a rebate to borrow AMC stock.
When all aspects of the short sale transaction and process are put together, this creates a “short position” for the short seller.
At a later date, the short seller will “cover” the short position. When the short seller does this, he or she will buy the same stock in the open market and the entire process that I have described above will unwind.
The short seller buys stock from another seller. The short seller’s broker will then pay for the stock out of its client account, by using the stock to then return the stock loan to the stock lender, freeing up the cash collateral and margin requirement in the process.
So, how does a short seller economically benefit from this series of transactions? Like any other investment. As a short seller, if you sell for more than you buy then you will generate a profit. The short sale process, however, creates an optical illusion since the sale comes before the purchase. Simply put, if the price of the short sale was greater than the price at which the “buy to cover” took place, then the short seller will make money. On the other hand, if the price of the short sale is less than the price of the buy to cover, then the short seller will lose money.
Please note that short selling has unlimited risk. When you buy a stock for say $100 the most that you can lose is $100. When you short sell a stock for $100 the loss is unlimited as theoretically, the stock price can go to infinity. Imagine shorting Gamestop (GME) at $20 per share a few million times and then the stock surges to $300. Ouch!
Requirements and Regulations
The borrowing and lending of securities is governed under Federal Reserve Regulation T. According to Regulation T, as it pertains to short selling, the short sale must take place in a margin account. Furthermore, the short sale must be collateralized by the short sale proceeds plus 50% of the short market value, which can be in cash or other marginable securities.
Short sellers cannot execute their orders with reckless abandon. They must obtain confirmation that their broker-dealer is able to borrow stock before transacting the short sale. This is referred to as a “locate.” As a result, the Securities and Exchange Commission (SEC) enacted Regulation SHO to control short selling and combat abusive practices.
The SEC states under Regulation SHO that: Short selling is legal except when done to manipulate the price of a stock. Quite often these manipulative practices are referred to as “bear raids.”
Broker-dealers must have reasonable grounds to believe that the security can be borrowed and delivered on the settlement date.
Broker-dealers are required to “close out” (i.e., buy into) short sales in “threshold securities” that have failed to deliver for 13 consecutive settlement days. Threshold securities are defined as having an aggregate failure to deliver for five consecutive days at a registered clearing agency, composed of 10,000 shares or more and at least half of the total shares outstanding.
“Naked” short selling, selling short without having borrowed securities, is not permissible unless it is for purposes of creating market liquidity and stability as is the role of market makers or specialists.
Short Sale Metrics
There are a few short sale metrics which are important to know:
- Short interest – the number of shares that are currently sold short
- Days to Cover (or Short Interest Ratio) – the number of trading days it takes short sellers cover their positions, based on the average trading volume (typically over the prior 30 trading sessions).
- Short Shares as a Percentage of Outstanding Shares – this represents the percentage of stock that is issued and outstanding for which there is current short interest.
Short Interest and Days to Cover metrics are published by the major stock exchanges and publicly available to view. Here for example is the short interest data for Bed Bath & Beyond (BBBY).
This was plenty to absorb. Part 2 will discuss what the Reddit Robinhood traders did and how hedge funds such as Melvin Capital Management lost billions and what roles Ken Griffin’s Citadel Securities and Citadel Hedge Fund played in the whole short squeeze episode that continues to unfold.
P.S. I can assure you that my old MD at Merrill Lynch, Joe R. will read this and make some comments or corrections, if necessary.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was not long any positions mentioned – although positions can change at any time.
Scott Rothbort is the President & Founder of LakeView Asset Management, LLC, a registered investment advisor specializing in high net worth private wealth management. For more information on investing with LakeView Asset Management, LLC call us at 888-9LAKEVIEW or request more information by clicking on the contact button on the top right-hand corner of the website. LakeView Management, LLC is a Nevada LLC, with its principal office located in Henderson, NV and branch office located in Millburn, NJ
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