Advertisement

In defence of short-sellers

To many people, short-selling – selling a company's shares in the hope of buying them back for less – is distasteful. But it does have its uses, says John Stepek.

879-Ocado-634
Ocado kept on delivering despite hostility from the shorts

The collapse of construction and support-services group Carillion has left a lot of investors looking at losses. But others will be cracking open the champagne. Hedge funds reportedly made at least £300m by "short-selling" betting that the company's share price would fall.

Short-selling sounds complex, but it's fairly simple. The short-seller (often a hedge fund) borrows the stock that it wants to short from an institution that owns it (often a pension fund). The institution is "long" the stock, but it's willing to lend it to the hedge fund in exchange for an interest payment.

Advertisement - Article continues below

The hedge fund then sells the stock. If the price goes down during the period over which it has borrowed the stock, the short-seller can buy it back and pocket the profit before returning it to the pension fund. As of July 2017, more than 25% of Carillion stock was on loan to short-sellers it was the most-shorted stock on the London market.

Profiting from disaster

The short-seller's profit is the difference between the original selling price and the price it bought the share back for. So if it borrowed then sold the share at £100, and the price fell to £75 before it bought it back, the fund would have made £25, less borrowing costs. However, if the price went up during this time, the short-seller would lose out. For example, if the price rose to £150 before the short-seller bought it back, then it would lose £50. And technically, losses are unlimited. A share price can only fall to zero but there's no limit to how high it can go. So it's very risky.

Advertisement - Article continues below

Some find the idea of profiting from a company's misfortunes distasteful.Yet the ability to profit by betting against a stock gives short-sellers a strong incentive to seek out and uncover bad business models and downright fraud, which in turn contributes to making the market more efficient and thus improves the process of allocating scarce resources to where they will be best put to work. After all, Carillion went bust because it was badly run, not because of short-sellers.

Shorts make for convenient scapegoats, but generally when a management team starts to accuse shorts of "attacking" its share price, you can be sure they're onto something witness the feverish denials from Britain's heavily shorted banks in the early days of the financial crisis. It's also worth noting that while hedge funds profited on this occasion, short-sellers also make plenty of expensive mistakes.

For example, online grocer Ocado has spent years on the "most-shorted" list, but has so far survived and cost many short-sellers their shirts in the process. Given the risks involved, we'd argue that the added scrutiny short-sellers can subject companies to makes their activities more than worthwhile.

Advertisement
Advertisement

Recommended

The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”
Investment strategy

The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”

Merryn talks to economist and author Andrew J Scott and discusses how we can profit from the "longevity dividend" as we live longer; why we need to re…
6 Aug 2020
Three mistakes to avoid when investing on Aim
Small cap stocks

Three mistakes to avoid when investing on Aim

Investing in Aim shares can produce spectacular returns. But as Michael Taylor of Shifting Shares explains, you have to have your wits about you.
5 Aug 2020
Too embarrassed to ask: what is “real return”?
Too embarrassed to ask

Too embarrassed to ask: what is “real return”?

MoneyWeek's latest "too embarrassed to ask” video explains what a real return is and why it's so important for investors.
5 Aug 2020
How safe are your dividends?
Income investing

How safe are your dividends?

Dividend investing can be a great strategy. But how can you avoid the stocks that are liable to cut your income? Phil Oakley explains.
4 Aug 2020

Most Popular

Don’t despair on dividends – these companies could be set to bring them back
Income investing

Don’t despair on dividends – these companies could be set to bring them back

The value of dividends paid out by UK stocks has plummeted this year as companies “rebase” their payment policies. But things could soon start to look…
6 Aug 2020
Platinum: the precious metal that looks set to play catch-up with silver and gold
Silver and other precious metals

Platinum: the precious metal that looks set to play catch-up with silver and gold

Gold and silver continue to soar, but there's still time to get in. And there's another precious metal that looks set to go on a bull run too, says Jo…
7 Aug 2020
The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”
Investment strategy

The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”

Merryn talks to economist and author Andrew J Scott and discusses how we can profit from the "longevity dividend" as we live longer; why we need to re…
6 Aug 2020