White Top View series Short Story on Short Selling, Part 7
Today in Part 7 of the White Top View series Short Story on Short Selling , we discuss unique risks of short selling. Short sellers must cope with all the usual market risks. However, short sellers face other unique risks in the pursuit of profit.
Links to the earlier parts of this series are available at the bottom of this post.
As has been previously emphasized, selling short is not a strategy for novice or inexperienced investors. High risks related to the facts, the market response and especially timing are in short trades.
Market risks of going short
As in any trade or investment, short selling has market risk. That means the price of the stock may move the ‘wrong’ way. In the case of a short seller higher prices hurt.
Short selling is a margin play. That means the short seller carries the liability that comes with borrowing an asset. In the case of a short seller, stock no capital gets borrowed.
As when carrying any liability, time costs money. In the case of borrowing stock, the costs to carry the loan can tip the balance for or against the short seller. A profitable trade can lose on costs.
Should the stock price move against the short seller, those losses can rapidly multiply. Such adverse price movement can quickly produce very significant and, in theory, unlimited losses.
Short sellers also carry unique risks
In addition to any market risks, short sellers face the risk that company management may take actions that move stock prices up. Risks of being financially hurt by management’s positive actions are unique to shorting.
For example, declaring a dividend when none existed before or in the case when there is a dividend, announcing a dividend increase can move a stock. Such news announcements usually bring in a wave of share buying by investors attracted to the dividend.
Such buying pressure can give a stock price strength and most likely pushes the price higher. Sometimes, sharply higher. Exactly what the short seller does not want to happen.
Other announcements can hurt such as new unexpected business or even simply negotiations for major new business contract. Also announcements of new products, markets, segments or regions can put company shares in play.
Any company announcing major new business often puts the shares in play and moving higher. In large or small companies very significant share price movement may result. Such price movements can quickly hurt a short seller.
Strategic review risk
A company struggling with business challenges or under pressure by substantial short selling may announce a ‘strategic review’. That is corporate speak or market jargon meaning the company is for sale. This is certainly one of the unique risks of short selling.
Hanging a “For Sale” sign on a public company certainly attracts attention. In addition to any prospective new controlling or ownership group, such announcements most often attract both investor and speculative interest.
A buying frenzy can result. When it does, there is only one way for the stock price to move. Up! That quickly leaves any short seller, that did not cover, well under water and drowning in losses.
Media and news release risks
At times company management and short sellers engage in media battles called dueling news releases. Management releases point out all the positives and why the company is or will soon be doing well.
Short sellers do not always respond with news releases but certainly do respond by freely expressing a negative view of management and the company. Any releases that do come from short sellers naturally point out what a disaster management has been or why prospects are so dim under this management.
Company management often feels very deeply and personally motivated. After all their jobs are certainly on the line. They will consider many actions or announcements to make life miserable or at least unprofitable for a short.
The media loves this stuff! Drama in business or boardroom battles always get top billing and open doors for interviews. The court of investor opinion matters because they vote by buying or selling shares in the company.
At times such battles are entertaining as any infotainment program available. At times some combination of bluff, poker and truth or dare get played in rooms of smoke and mirrors. This is the most bizarre of the unique risks of short selling.
Dividends Costs Add Up
Although we discussed dividends in Part 6 of this White Top View series Short Story on Short Selling , the risk of dividends need mentioning here.
Dividend costs can change. Two changes can happen, either the dividend gets increased or the timing of the short trade is significantly off.
Should the board raise the dividend, costs immediately spike! Should the timing be off and short position has to be carried longer than planned, the short seller must cover multiple dividend payments.
In either case cost escalate. Costs or share price increases have a huge negative financial impact on the short. The short seller has to get it right.
Calendar game risks
The calendar risk can surprise a short. Corporate boards set dividend amounts and dates. It is within their power to change either or both the dividend amount or date. Naturally, because they can, they do.
The owner of a stock, at the market closing, the trading day before the ex-date, is due any dividend. The ex-date is the first day of a new (future) dividend period.
Buying a stock on the ex-date means the new owner does not receive the previously declared, but not yet paid dividend. The payment delay or real payment of the dividend may happen a few days later. Paying two weeks after the ex-date is a common occurrence.
Here is a nasty bit of gamesmanship. Boards can move the ex-date up the calendar forcing earlier payment of dividends. That can substantially increase the short seller’s costs.
Shorts will certainly call foul! They will launch lawsuits and keep a bunch of lawyers busy as will the company!
Warrant and spinoff risk
The nastier of the unique risks of short selling includes both warrant and spinoff risks. Management can issue warrants to all shareholders. They can sell, disperse or change major parts of the company targeted by the short seller.
That can mean selling assets or divisions or spinning them off to shareholders or to third parties. Making any such moves can vastly change the values recognized by the market.
It can also move the value away from the short’s position or significantly dilute the ownership value of a share. It can also have the effect of issuing multiple shares in different companies to the same shareholders. That can keep all shareholders happy, except the short who sees value melting away.
Complicated certainly describes the many possibilities. In a flash the short may find they are now short two or more securities. Suddenly they are holding a far more complex and costly position.
Then imagine the financial horror if two or more share prices move against the short at the same time! When battles get nasty they get loud. That attracts a crowd.
Share trade volumes very often can come alive and the show it on! Bets get laid and stock prices can very significantly move. Most often up.
Rather than further exploring that complexity and many permutations, the point is, very high risks lurk. Shorting get complex and carries significant risks. Once you have some much experience and comfort with markets, you can consider such a strategy. Until then, don’t touch!
Next time we will cover the rules shorts must follow.
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To read all parts of the White Top View series, the Short Story on Short Selling, click the links below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling
Part 12, Shorting stocks is hard