As if they’re aren’t enough potential sources of stock market volatility, we also have to contend with abusive short-selling practices from time to time.
Short selling has long been a legitimate practice. In its basic form, an investor sells securities he or she does not own. Later, he or she buys them back, hopefully at a lower price, which generates a profit. If the repurchase is done at a higher price, then there is a loss.
For example, suppose you don’t own any shares in XYZ Corp., which currently trades at $10.00 a share. You think it’s overpriced and due for a come down, so you arrange to borrow 1,000 shares of XYZ from your brokerage firm, and sell them into the market at $10.00 each.
How to profit selling stock you don’t own
Some time later, suppose the shares trade at $8.00 each. You enter an order to buy 1,000 shares of XYZ, which effectively cancels out the shares you borrowed. So you’ve sold $10,000 worth of shares, and bought them back for $8,000. You therefore have a $2,000 profit sitting in your account.
At least, that’s how it works if all goes well. Of course, the shares may not cooperate with your plans. For example, if XYZ never goes below $10,000, and continues to rise in price, you may have to buy them back for a higher price, and take your commensurate loss.
Technically, there is no time limit on short sales; you can wait to repurchase the shares for as long as you like. Practically speaking, however, interest charges at, say, prime-plus-something accrue on the borrowed amount until you do repay the loan, and you’ll have to post margin as well. So, in effect, the sooner the shares go down in price, the better.
The pros and ‘cons’ of short selling
Short selling is a controversial strategy that has plenty of detractors. On the one hand, short sellers provide a valuable service to the market when they discover fraudulent practices by a company and bet against it.
On the other hand, abusive practices related to short selling have caused many market watchers to call for tougher short-selling rules. This happens when short sellers target a company by bending the truth about it through exaggeration and misrepresentation in the hope of causing shareholders to panic and sell their shares. This, in turn, drives the share price down accomplishing the unethical short seller’s goal.
Stock market manipulation of this sort has been on the increase in recent years, affecting even securities we recommend in Money Reporter.
Manulife under attack by short sellers
Last October, global financial services stock Manulife Financial Corp. (TSX—MFC) found itself in the crosshairs of short sellers when a firm specializing in such sales, Muddy Waters, claimed that the company’s Canadian subsidiary had “just concluded a trial that could significantly damage its earnings, capital creditworthiness, business and solvency”.
Manulife’s shares closed down nearly three per cent on the day Muddy Waters announced it was shorting them. In the days that followed, the shares, which had traded about $23 before the announcement, fell to about $20.
At issue, was a case brought against Manulife by a hedge fund that claimed insurance contracts issued by the insurance company dating back to 1997 allowed it to deposit unlimited money with Manulife and earn a guaranteed return of least four per cent per year.
As it turned out, a Saskatchewan court subsequently ruled the fund could not treat these insurance contracts as “unlimited stand-alone investment opportunities”. This has lifted an overhang from Manulife’s shares, which, after the market meltdown of last December, are now trading around $23 again.
Plenty of observers have recommended steps to clamp down on this behaviour, but until such time as these solutions are adopted by regulators you have to be aware that any security in your portfolio is a potential target.
This is an edited version of an article that was originally published for subscribers in the May 31, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
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