Shorting stocks is a very emotive subject for us in Britain.
Because of the existence of Stamp Duty on most UK equities and until recent times costly execution fees on physical equities and high margin requirements (in relation to other classes such as forex or indices) we haven't become a nation of emotionless day traders as seen in a market such as the US. We remain investors and carry all the associated emotional baggage. Generally this investment manifests itself as taking medium to long term long positions planning on either income yield or more commonly, capital growth but also, at times, holding a position short in order to gain from a belief that a stock is overvalued.
But shorting doesn't come naturally to British equity traders. The same trader is not likely to think twice about placing a short bet in Cable or the FTSE Index but when it comes to equities there is more emotion to our trades. We tend to invest emotionally in our equities because they are longer term holdings and we have studied them and gotten involved in their machinations. And we naturally form crowds around our belief that can help our investment but also hinder, if honest.
Typically there are two common types of equity shorts at any time in the market. There are the portfolios that will take small, short term shorts against large long term holdings in a blue-chip where they feel the share is likely to underperform in the short term but the reason for holding the long term position remains valid. It is a way of generating a small additional income on an investment portfolio, in a similar vein to those who write options against their holdings.
The second typical short comes from pairs trading. Most commonly taking the stock within a sector which is outperforming, trading on a premium and shorting it against the stock that is under performing. In recent times the most obvious example of seeing this work was in the retail sector with Tesco’s. A stock which we all knew was failing to expand overseas, struggling to grow in the saturated UK, losing share to the new German arrivals but still carried a hefty premium. All it took was a little story about an accounting error and that premium came off rapidly.
But there is a third type of shorting that is just as legitimate, arguably more important but far more emotionally charged. It's a type of shorting where the same crowd who usually behaves like spectators at Lords suddenly behave like intensely tribal football fans on derby day. Essentially it is the 'Death Match'.
Such an event will lead to open warfare between the buy and the sell sides and this isn’t a modern armchair war of surgical strikes directed from positions of comfort but a traditional, Classical, blood bath of face to face, hand to hand vicious bloodletting on both sides with long periods of not knowing which side is winning. The ebb and flow of these dirty battles, like referencing Agincourt or Waterloo will ultimately come down to being decided by a defining event within the struggle, sometimes it is clear to see like the advantage of the English longbow man removing the leaders from the field or the Prussians arriving to tip the numbers but often it comes down to a subtle act such as the French cavalry failing to spike the British guns when they over ran the artillery. But it is a dirty, vicious, exciting event where new allegiances are formed, old broken and for either to be reversed again at the next battle.
It nearly always happens on a stock which has been driven up hugely by retail or small fund demand, releases a lot of news flow and carries a very hefty premium in traditional accounting terms. Any stock like that will come under scrutiny and there will always be people who want to look much more closely before investing. Generally, people don't go looking for the short it is something that is found while looking for an investment. When a chink is discovered it will be delved into more deeply and on occasions it can reveal what could be a complete house of cards. Often the revelation is based around the product the company is selling, that it either doesn't work or that it's potential market is far smaller than the company believes but the revelation can also be related to the structure of the company from carrying too many debt obligations to erroneous accounting and even a fraud. Sometimes the short is actually malicious and without true grounding. A company which has climbed rapidly and carries a hefty premium will be illiquid and therefor volatile. This raises the opportunity for the less scrupulous to set a short bet and then attempt to trigger a sell off to capitalise. Whatever the reason, anyone looking to short a particular stock or to understand why others are must delve deep into the stories, wade through the inevitable skirmishes and spats and attempt to establish their own view on the matter. There is nothing to be gained in sticking to the original criteria for a long investment and keeping ones head in the sand. The arrival of a short scenario has fundamentally changed your original criteria and you must re-evaluate your position. Do you hold, reduce, add, sell or short those are the five new questions and it is essential that you are honest with yourself. Nothing to be gained by fighting your own personal view as well as fighting the market.
My own personal view on shorting as both a broker and an investor is that it is an essential tool that works to keep our market healthier, it would be fundamentally wrong to not have access to the most efficient tool to combatting market bubbles. The upsides far outweigh the downsides.
However, many people don’t fully understand shorting, even those that enter into a short position. In order to sell something that you don’t own, you are still obliged to deliver that stock to the market and so must borrow it from someone. The ‘Lend’ as it is typically called will often come at a price as the owner will want you to pay a fee for borrowing his stock and the risk associated with this. In the physical market this can be an added spread wrapped into the position, so you are paying it all up front regardless of how long you hold for; on the OTC side it tends to be a daily funding charge. The less liquid the stock the higher this charge is so it is common for the broker to negate payment of interest on the short position to cover this borrowing charge and not uncommon for the broker to have to levy a positive charge to cover the cost to the lender. So you can end up running open ended costs to hold a short position. At the same time the lender has the right at any time to call in his stock from you and you will have no choice but to buy it back in the market at whatever price it is trading at in that size. A not inconsiderable risk that you carry on top of the funding aspect, don’t forget that you have borrowed from an entity which is long and has a clear vested interest in the price rising, not falling. At the same time you are also holding an obligation to cover any corporate actions over the period, so must pay any dividends for example.
The general workings of shorting however, are well publicised so a trader/investor wouldn’t get caught out if they make the basic effort to research and understand what they are getting involved in. The reason for me penning this article lies in something that I learned back in 2001 and something which is not so clearly spoken of on the web and also is variable depending on the broker in question.
To give you a little bit of background on myself, prior to founding CFDs.com I was the Institutional Business Director at IG Markets. I actually joined IG back in 2001 on the sales side of the newly formed CFD side of the business. There were only a few of us back then and our main competition was MF Global (nee GNI). My background prior to 2001 had been one of working for one of the oldest private client brokers and asset managers in the City, a then stuffy industry where my lack of a double barrelled name was always going to hold back my career progress. The move to IG after a stint at a US bank was an eye opener to say the least but one event from my early days remains in my memory and has been brought back to me while following the Quindell situation and that is the putting of Railtrack into administration and the subsequent suspension of its listing before the market opened on Monday 8th October 2001. It was the first time that I had witnessed such an event from inside an OTC broker as opposed to a traditional, physical broker and there were differences.
First of all, the number of short positions held. With a physical broker going short back then was complex, costly and generally not done by the typical client of such a broker so when an event occurred the small number of clients who were short were simply told to wait in line along with the longs until the appointed administrators settled on a final price for the stock. This is a period of time that is typically not known but is going to be months not days, sometimes years!
In the world of CFDs and Spread Betting, it is different. And it will vary between brokers as they all make their own OTC market and will decide what their course of action will be.
Unlike with physical brokers the number of clients sitting on shorts will be much, much larger. What this means is that the spread betting firm has to take into consideration the PR impact of their actions. This will be a significant number of clients and by the nature of those who short, usually a long term and valuable group of clients. They also have large, unrealised gains, and bluntly you do not want them taking these gains to your competition.
In addition, these clients will still be paying daily borrowing costs for their position, so you are faced with a situation as a broker that you know the final settlement agreement from the administrators is likely to be months away but you have long clients who have potentially lost the entire value of their holding so must pay the outstanding margin up to 100% while also still paying their long daily funding as well as the short holders who have the natural desire to cash in their winnings as well as not to keep bleeding the daily borrowing costs. In short, what you have are two parties at one brokerage where the reality is that it is in their best interests to do a deal together to net off longs v shorts at a price above zero that is acceptable to the majority of both sides of the camp. This netting off is also possible at a traditional brokers but it is more complicated as it involves Settlement processes and physical deliveries and as there are typically far fewer clients on the short side honestly not worth the work, unlike a spread betting firm where the positions either way are just digital contracts based on an in-house price so easy and cheap to net off and settle as it is all internal.
If we go back to Railtrack for a moment, what happened when trading was suspended is that being such a large company and given the nature of its collapse the market was pretty confident that the administrators would give a final value that was at least above zero. Because there was an enormous amount of stock out there a secondary market appeared where funds offered to buy stock from holders, they obviously were looking to take advantage of the turmoil and would set a buy price below what their analysts believed would be the final settlement level and hence turn a profit. This process allows a spread bet firm to set a netting off price for their clients quite easily as this third party process is all quite public, it is simply a trade based on an existing, external market.
In the case of Railtrack this secondary market was so large that it actually operated on the LSE. What you saw by summer of 2002 was that the administrators had announced they would be paying around £2.50 per share in two instalments with the first instalment being about £1.70 and paid in 2003 with the second instalment paid the following year. That’s an extremely long time to be funding positions or waiting for your money. But you could actually trade Railtrack and the price was around £2.00. This discount obviously reflected the cost to the buyer of holding the paper until the formal pay-outs occurred.
Smaller stocks do not have the size to warrant an actual listing on an exchange for this but if large enough will attract a fund or two who will run such an offer privately and make their pitch to investors via the share register and/or media. When you get down into the small cap range this is almost non-existent. The broker will have to determine the fair price for the netting off itself with no external reference. The broker is naturally and logically not immune from the PR perspective. It must look at both its long and short client book and try to determine the level that will appease the most. It is a no win situation for the broker as there will be disgruntled clients on both side.
Logically, fewer on the long side as they will have started to reconcile the total loss and so any return is seen more favourably, but what is very common is to find that the short holders have mentally valued their winnings based on a price of zero and so see any settlement (regardless of the actual savings to them) as almost a theft but with the additional crime of their winnings actually being paid to the losers with whom they have been engaged in this messy battle with.
The advent of social media means two things today, firstly it can be used as a tool for holders, both long and short to work as collectives to lobby their broker to settle at a reasonable value to both sides (because they do have to settle, effectively the battle for the peace) but at the same time it becomes a tool for brokers to compete against each other. As the settlement price is determined internally and it is not a price where the client can arbitrage one broker’s price against another to ensure an efficient market the brokers can end up offering differing settlement levels based on the positioning of their book. What will typically happen is that most will wait until one of the largest brokers in the market place issue their price and then simply copy that but it is important to understand that it is also a marketing opportunity for us brokers, we live or die by the number of clients we service and if we find ourselves with little to no exposure to the stock in question then there is a clear advantage to us quoting a settlement level that is out of step with the competition, one way or another, so that we stand out from the crowd and gain media time. If the battle ground is churned up and muddied prior to a suspension or de-listing it isn’t going to become any cleaner or organised in the immediate aftermath.
So, in short, whether long or short of a stock that looks to be entering a terminal phase it is crucial that all holders grasp the risks and benefits of being involved when or if that play comes to an end. It can come to an end in several ways from a new board parachuted in to clean up, an MBO, to a white night or just being pulled apart by the administrators but however it happens it is important to understand that your broker may act differently from other brokers and to look at how they have acted in the past. DYOR is a much laboured, obvious and sensible mantra and it applies far more importantly to your exit strategy than your entry. If you do not fully understand the ramifications that lie ahead then the best course of action is to speak with the firm that you have contracted with. We are not evil but we are businesses that exist to be profitable and the more our clients talk to us the more we can be educated as much as them.
Tim Morris is a senior partner at CFDs.com a boutique spread betting and CFD brokerage in the UK and EU that services small to medium sized clients.
