What is short -selling of stocks
Let’s separate the answer in several parts: the mechanics, and the objectives
The mechanics of short selling:
Selling short is a bit more cumbersome than buying long. Mechanics are as follows:
Borrow shares now: shares need to be available for borrow. This is a function of supply (long holders lend a portion of their long holdings) and demand (short interest from short sellers). Stay away from crowded shorts, i-e where borrow utilisation (supply/demand) >50%
Sell them short: once borrow is located, sell them. You will receive cash.
Buy them back at a later date, pocket the difference. Short cover decreases your cash balance. Make sure You have enough cash to cover
Additional considerations are margin requirements. This varies by jurisdiction, client type etc.
The objectives of short selling:
This falls into two buckets: retailers and absolute players and the institutional market participants.
Retailers and Long Short 1.0
If you are a retailer or an absolute player, you expect the price to go down in absolute. Example: sell at 100, buy back at 90, pocket 10. There is a 1 to 1 relationship between the absolute price and the P&L. Simple yet anything but easy to put in practice.
This is what a lot of Long/Short funds do and the main reason why they fail in practice (more on that later down).
Institutionals Long/Short 2.0
If You have a complex portfolio, i-e long and short books, your objective is not to short stuff that will go down in absolute, but in relative. You want to short stocks that will underperform your benchmark on the short side and buy those that will outperform on the long side. Money is made in the spread between outperformance and underperformance.
There is not a 1 to 1 relationship between price and performance. Example: Your benchmark is MSCI World in USD. You short a Japanese stock at 1000 JPY. You cover 1 month later at 1000JPY. Absolute performance = 0. Yet, in the meantime, MSCI World has moved +2% and JPY depreciated by -1%. Effectively, you will have clocked a 2+1=3% return.
If it is so complicated why would You go the 2.0 instead of 1.0 ?
The cons of 1.0
Absolute 1.0 are laggard indicators: there is no worse insult to a fund manager than being told he is a laggard indicator, apart from being a reverse indicator… Stocks first underperform their competitors. then, they underperform their broader sector. Then, they underperform the index. Then, finally, they drop in absolute. So, if you have waited for price to drop in absolute, you have effectively lagged the market.
Scarcity of ideas: shorts that drop in absolute in a bull market are few and far between. They attract a lot of attention, i-e tourist short sellers. Chances are it will be crowded, prone to short squeezes and volatile. Look at TSLA. It is probably a short, but hardly a profitable one between the cost of borrow and volatility
Beta hedging: Long 1.0 has implicit directionality built-in. Few ideas mean big concentrated bets if you want to lower net exposure. This alsomeans you will not be hedged on the net Beta side. This means high volatility. This is why long/short 1.0 fail to generate alpha. They are Beta jockeys during bull phases and suck air during sideways or bear
The pros of 2.0
You will be a short selling guru: the flip side of going relative is that you will spot shorts long before price starts to drop in absolute. Ideally, as soon as something starts to underperform their sector, short. In practice, you will look for underperformers at the market level. You will start to short long before the crowd. Example: short Lehman Brothers 1 year before its collapse, and welcome to the pantheon of short sellers
You will be an idea factory: the index is roughly equally split between underperformers and outperformers. So, You will always more ideas than you have cash to deploy. Sector rotation means there is always something to short: oil then retail etc.
Low volatility: lots of ideas translates in low concentration, which results in low volatility of returns. Remember that investors pay more attention to volatility than to returns. This means You will have an attractive product
Sorry, this was a verbose and technical answer. Now, let’s elevate the debate to why you would sell short
Why would You sell short?
Historical perspective: during WWI, horse was the dominant mode of transportation. One day 1 of WWII, the world woke up to the Polish cavalry being mowed down by a German panzer division. Today, horse carts run around Central park. No-one sheds a tear for the dead horse cart industry. Kodak was the dominant player. Today everyone has a camera in their phone and Kodak is a case study in top management arrogance. Evolution does not take prisoners.
For every Apple 2.0, there is a legion of failed computer manufacturers Apple 1.0, NEXT, Sinclair, IBM etc. For every winner, there are many more losers, also listed on the stock exchange. Instead of betting on a distant potential winner, it is statistically safer to bet on the multitude of losers. That is called diversification.
Markets go up, down and nowhere. 90%+ market participants play one side: they buy. Markets have dropped by 50% twice in a decade. They will probably have another soft patch. Are You sure You want to bet your life savings on them going up forever? Let’s be honest for one second. As a long only player, don’t you have a nagging fear of markets going down? If You learn to sell short, at least you give yourself a chance to profit from downturns as well.
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