Short selling – what no one had told you before

We already discussed short selling in the past, but we did it viewing only the micro-picture, from the short seller point of view. What happens to the stock from the macro point of view? Or, in other words, how does short selling affect the stock overall price?

Well, this is a tricky one. I’ll try to explain it using some examples, you might be surprised from what you are about to read.

The intuitive answer will be that short selling lowers the share price. This is, of course, true. But why does this happen? It is not as trivial as you might think.

Let’s first discuss conventional short selling (as opposed to naked short selling). Imagine a certain broker, such as E-Trade. When one wants to short a stock, he must borrow it first. Usually, he asks a stock to borrow from his broker. His broker chooses a stock available in one of his other clients’ portfolio and lends it to him, taking a certain fee or interest. Then the stock is sold in the market.

The only possible way the broker could have lent the stock to the short seller is because this stock was not supposed to be sold in the broad market. It is a stock that belongs to a rather stable pool of stocks that the broker, in our case, E-Trade, holds. For example, they belong to investors that hold the stock for a long time. If these investors will start selling the stock, the pool of stocks available to E-Trade to lend others shrinks, and the broker need to call back the stocks he lent for his "stable" clients will be able sell.  In this case, the short seller can get a “recall” call to buy back the stock and return it to the broker. Let’s assume the pool of available stocks to sell short is stable for the sake of our discussion. So we can conclude that when the pool of stocks available for short selling is stable, stocks that are sold short are stocks that would not have been sold if there wasn’t for the short seller.

Taking this conclusion into mind, we understand that short selling adds sellers to the market. As we know from basic micro-economics, when the seller-buyer balance is tilted towards the seller side, the price declines.

So, is this all there is to it? NO. There is more.

Let’s take an example – Investor A is a long-term investor. He will hold 10 shares of company X for a long time, and he will serve as our stock pool from which we can borrow stocks to sell short. Let’s also assume Company X has only 100 shares, the other 90 not held by investor A are held by investors that would not sell or loan to others. Investor B is a short seller. He asks his broker for 10 shares of company X to sell short. The broker lends him the 10 shares that belong to investor A. Investor A does not even know this had happened. Investor B proceeds to sell these shares in the broad market. Investor C buys the 10 shares sold by investor B.

Now here is when it gets interesting.

As we know, a share in a company is a claim on all the benefits of owning a piece of the business – voting, earnings, and of course, dividends. Lets take dividends for example as this is the easiest to explain.

Company X declares and distributes a dividend, say a total of 100$ or 1$ per share. Who will get this dividend? Any investor holding the stock (during the record date) will be eligible for the dividend.

This is done by the stock exchange clearing system. This system gets a list of accounts with quantities of shares of company X that belong to each account. It then charges the company for the dividend amount, 100$, and credits the accounts of the shareholders by the amount of dividend per share times time quantity of shares held per each account. Pay attention that the list of accounts also has accounts with negative amount of shares – to account for short sellers. We’ll get to it.

In our example, investor A does not hold the shares! He does not know this, but his shares were already sold to investor C. Will he get the dividend? Of course he will. The stock exchange clearing system knows that this investor lent his stocks to someone else. In the list sent to the exchange, next to his account there will be  the number 10, for the 10 shares that he held. He is entitled to get the dividend. What about investor C? Investor C bought the shares sold short by investor B. Investor C is actually holding the shares, so he is also eligible for the dividend and his account number will also be sent to the exchange with +10 shares next to his account number.

Let’s see where are we standing: Investor A that held 10 shares of company X is entitled to 10$ dividend. Investor C that bought the shares lent by investor A, is also eligible for 10$ dividend. But this transaction only involved 10 shares, where will the rest of the money come from? The answer is, of course, out of B’s pocket.  The clearing system got B’s account with (-10) shares of company X, so B will pay 1$ per share dividend to investor A, whom he borrowed the shares.

But this is not the bottom line. Previously, before the short selling, only 100 shares got a dividend.  Now, 110 shares will get a dividend: 90 held by other investors, 10 shares held by A, 10 shares held by C. What does this mean? This means that in effect, the shareholder base of the company was diluted, because more than 100 shares are entitled to the company related benefits.

Yes, short selling effect is similar to the effect of a temporary dilution.

You can look at it in this way – every company has a finite set shareholders. Short selling satisfies buyers that would otherwise buy the share in higher price. It turns the long time holders into sellers. Short selling not only adds sellers to the market, but also effectively adds new shares.

Previously, this finite pool shareholders would have been given a 100$ (1$ per share) of dividend from company X, now this pool of shareholders receives 110$.  When there is more supply of the stock, similar to a dilution, as with any asset class – this lowers the price.

Naked short selling is even more obvious – this really adds new shares into the market.

When you see that a company has 35% short interest – this means that this company is in the state of a temporary (reversible) 35% dilution. The effect of short sellers covering will be as if the company had repurchased 35% of its stock – but in a very short time frame – or a short squeeze.

When I see a company with a large short ratio (ratio of shares sold short to total shares of the company) it actually provides me with a bigger margin of safety – because in effect there are more shareholders of the company then there should be.

EDIT: It seems some readers still did not understand the ramifications of short on the effective shares outstanding. When you see a company with 30% short ratio, and, for instance, this company has 100 shares outstanding, this means that there are holders for 130 shares. Of course that some of them only hold a "promise" for a share as there are only 100 real shares, but the holders do not even know about it. Maybe shares in your favorite holding were lent to someone else?  You can't tell. For all you know, you are holding the stock. But it is very likely that your shares went on to be sold short to satisfy a buyer, that if there were not short sellers in the first hand and you wouldn't have sold your shares – this certain buyer would have to try harder to get the shares and the price would have risen.