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Short Selling and Leverage - How they get busted

[Gabriel]

		Chapter 5 - Short Selling and Leverage All About Hedge Funds, Second Edition by  Ezra Zask McGraw-Hill © 2013 Citation Recommend?

 

Chapter 5: Short Selling and Leverage

To achieve their objectives, hedge fund managers use a "toolkit" that contains the following tools:

• Short selling

• Leverage (borrowing)

• Derivatives

SHORT SELLING

Short selling is the sine qua non of hedge funds, as implied by the "hedge" component of hedge funds. To "go short" or "sell short" or "take a short position" or "shorting the market" means to establish a position on a market or individual security such that the position will benefit if the price of the market or security declines. In the simplest example, a short position on IBM stock will make money if the price of IBM declines. Conversely, a short seller will lose money if the price of IBM goes up.

There are several ways of "going short" depending on the specific market and instrument. To give just a few examples:

• Shorting an individual stock, the classic type of short selling.

• In a more complex and more recent type of transaction, a hedge fund can short the credit of a mortgage-backed security or a corporate bond by selling a credit default swap.

The short sale of an individual stock is a strategy used in a number of hedge fund strategies. For example, long/short equity hedge funds short stocks on the basis of their view of the direction of the stock’s price, or related pair of stocks. 

Mechanically, a short stock sale is achieved as follows:

1. The hedge fund initiates the position by borrowing a stock from a broker/dealer. The dealer will in turn normally borrow the stock from customers who maintain long positions in the stock with the broker in return for a small fee. This transaction is known as "securities lending." Many large institutional investors such as pension funds, insurance companies, and mutual funds allow securities in their portfolios to be loaned out as a way of earning incremental income.

2. The fund then sells the stock in the open market and deposits the proceeds in a margin account with the broker/dealer as collateral for the borrowed stock.

3. To close out the position, the fund will buy the stock in the open market and return the shares to the lending dealer.

Risks in Short Sales

Short selling is not simply the opposite of buying and holding a stock position. It requires specialized skill and introduces a level of complexity and risk not found in long stock positions. It is for this reason that managers whose background is entirely or predominantly on the long side, for example, working for a traditional mutual fund, sometimes find it difficult to adapt to the hedge fund world. There are a number of risks that are unique to shorting stocks:

1. Unlimited loss potential: In a traditional long position, the manager’s losses are limited to the amount he spent to purchase the stock. However, in a short position, the loss is theoretically infinite since the price of the stock can rise without limit.

2. Stock loan difficulties: Short positions in stocks with high levels of short interest (i.e., high demand by hedge fund and others to short the stock) may be difficult to implement. For example, the stock may be impossible to borrow, or can only be borrowed at a high cost.

3. Stock "call-in": A stock loan may be "called-in" by the stock lender, causing the manager to buy the stock at the market price, which may mean forcing a loss.

4. Margin call: If the price of the stock rises and triggers a margin call from the broker, the hedge fund must come up with additional collateral or purchase the stock at the market price, typically at a loss since the margin call implies the stock’s price has most likely risen.

5. Short squeezes: A short squeeze is a sharp increase in the price of a stock caused by short sellers attempting to cover their short positions at the same time. This is especially acute for stocks that are thinly traded or where supply is limited. A recent example is the sharp rise in the price of Porsche stock as hedge funds that had shorted the stock scampered to purchase the stock to cover their large short positions. However, there was a limited supply of Porsche shares, which caused a spike in their price and resulted in billions of dollars in losses for the hedge funds.