Friends, the article today is seriously hardcore! I'm telling you, while I was preparing for this, all sorts of knowledge points and ideas just kept popping up! Are you ready, friends? Today, let's talk about short selling!
Understanding Short Selling
When it comes to short selling, we often picture Wall Street players making big moves. For instance, in the movie The Big Short, they shorted the subprime mortgage market. Then there's Muddy Waters shorting Luckin Coffee, a Chinese stock, and George Soros shorting the British pound. And let's not forget the WallStreetBets saga of last year, where retail investors went head-to-head with hedge funds.
So today, I'm going to combine these colorful and classic cases – some successful, some not – to unravel the logic behind short selling. We'll explore what it is, the various ways to play the game, and why it's not as simple as you might think.
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The concept of short selling isn't actually that complicated. If you already know what it is, feel free to skip this part. You see, under normal circumstances, if we want to invest, we buy a stock or a futures contract that we believe will go up in value. When it rises, we sell it for a profit.
We know that financial products can go both up and down. So, what if I expect a stock to go down? Can I still profit from it?
It's simple. Just reverse the order! Sell it first, wait for the stock to fall, then buy it back at a lower price, and voila – profit! This is short selling.
Of course, some people like to get technical and differentiate between short selling and shorting. But in most cases, they're used interchangeably, so we'll do the same today.
Now, you might ask, to short sell, you need to sell first and buy later. But what if I don't own the stock? How can I sell it?
You're onto something! This is where you need to find someone to borrow the stock from. You borrow it, sell it, wait for it to fall, and then buy it back. After buying it back, you return it to the lender.
Here's an example: let's say you're bearish on a stock, "Lao Wang Milk Tea". Definitely not "Lao Liu Milk Tea"! Lao Wang Milk Tea is currently trading at $100, but you believe it's going down. So, you want to short it. However, you don't own any shares of Lao Wang Milk Tea. What do you do?
You notice your neighbor, Lao Li, owns some shares. You ask him, "Lao Li, could you lend me some of your Lao Wang Milk Tea stock?" Lao Li lends you the shares, and you sell them, receiving $100.
As expected, the stock drops to $50 a few days later. You buy it back for $50, and the remaining $50 in your hand is your profit. You then return the shares to Lao Li, and everyone's happy.
Lao Li didn't lose anything, as he was planning to hold the stock long-term anyway. But you, on the other hand, made a cool $50 profit! That, in a nutshell, is the basic process of short selling a stock – borrow, sell high, buy low, return, profit!
The Realities of Short Selling
The process seems straightforward, but let's dig a little deeper. You might have similar questions as I continue.
First, where do you find people like Lao Li who are willing to lend you their shares? Second, even if you find them, why would they lend their stock to you in the first place?
Let's address these questions.
Firstly, to find your "Lao Li", you need an intermediary, typically a brokerage firm. Since many people have accounts with them, they know who holds shares of "Lao Wang Milk Tea" and can connect you with potential lenders. If you're a large institutional investor, investment banks have dedicated prime brokerage departments that handle this for you.
Secondly, shareholders don't lend out their stocks for free. Just like borrowing money incurs interest, borrowing stocks does too, which we'll discuss later.
So, in theory, short selling is the reverse of going long – one bets on the stock price rising, the other on it falling. That's it.
Now, most people would stop here when talking about short selling. But look at our progress bar! We're just getting to the interesting part. Let's see what short selling looks like in the real world.
The Risks and Rewards of Short Selling
We said earlier that the lower the stock price drops, the more money you make. If Lao Wang Milk Tea was at $100 and went bankrupt, theoretically, you'd make a $100 profit. However, if there's a piece of positive news, say a collaboration with "Lao Liu Milk Tea," the stock could skyrocket to $200, $300, or even $400! Your losses would then be $100, $200, $300, and so on. The higher it climbs, the worse your losses.
And here's the kicker – this is unlimited. This is the first key characteristic of short selling: you face limited profit potential and… well, you get the idea.
In theoretical models, this might not seem like a big deal; it's just a characteristic of the return distribution. But in reality, this can cause fund managers to lose sleep... and hair. As a short seller, you constantly face the possibility of a stock doubling or tripling within a year.
Take the US stock market, for instance. From March 2020 to 2022, it doubled! Imagine the stress for short-selling institutions.
Remember the Enron scandal we discussed before? There was a famous short-selling legend who, in 2001, analyzed Enron's financials and discovered problems. He went short on Enron in a big way and made a fortune – $5 billion to be exact – instantly becoming a Wall Street legend.
He then successfully shorted Luckin Coffee, Wirecard (a German company involved in financial fraud), and Hertz (an American car rental company that went bankrupt). Impressive track record, right?
But even the best stumble, and as we said, short selling comes with the risk of unlimited losses.
In 2016, this famous short seller, after rigorous analysis, set his sights on Tesla. He looked at the fundamentals and concluded that Tesla's stock price was absurdly high compared to other automakers like Mercedes-Benz and BMW. It made no sense to him.
So, he started building a short position in Tesla and publicly expressed his views in interviews. For the first three to four years, things were okay. Tesla's stock price fluctuated normally because the market wasn't sure what to make of Elon Musk's company.
Then, in 2018-2019, Tesla's production began to grow exponentially, and doubts about Elon Musk began to dissipate. Initially, when the market hadn't fully reacted, our short-selling friend had a chance to retreat. But not only did he not withdraw, in an interview at the end of 2019, he even went as far as claiming that Tesla was severely overvalued.
We all know what happened next.
Tesla's stock went through the roof, rising over 1,800% since he started shorting it. Thankfully, he had a rule – no single stock could exceed 5% of his portfolio. This principle saved him from a catastrophic loss.
But even so, investors were running for the hills, pulling out their money. And it wasn't just him. Tesla has been the most shorted stock in history, he was just the most vocal. You could say those short sellers were unlucky to encounter Elon Musk. Statistics show that in 2020 alone, Tesla short-sellers lost a combined $40 billion. Just imagine the amount of hair lost!
Another example: before the 2008 financial crisis, many short-selling institutions had already seen the housing bubble forming. In The Big Short, fund manager Michael Burry started betting against the banks through various financial derivatives like credit default swaps (CDS). As asset prices rose, he kept losing money. He was even forced to prohibit investors from withdrawing funds, enduring each day with immense pressure. He barely made it. Fortunately for him – or unfortunately, depending on how you see it – the subprime mortgage crisis erupted, and he survived. Many other short sellers weren't so lucky.
The bottomless nature of short selling makes it terrifying for fund managers. A single misstep can ruin a stellar reputation, as our Tesla short-selling friend learned the hard way.
Mitigating Risk: The Long-Short Strategy
Because of the high risks associated with purely shorting stocks, very few hedge fund managers focus solely on it. In most cases, short selling is accompanied by hedging. When shorting one stock, they simultaneously go long on another or buy index futures.
This is a very common hedge fund strategy called "Long-Short Strategy."
For example, if I'm bearish on "Lao Wang Milk Tea", I can short it. But I'm also worried about a broader market rally. So, I can go long on a more stable stock like "Lao Liu Milk Tea". In this scenario, if both stocks rise or fall simultaneously, my returns remain unaffected. In other words, my long position offsets the market risk of my short position. This is sometimes referred to as "beta."
I only profit if "Lao Liu Milk Tea" outperforms "Lao Wang Milk Tea."
It's worth noting that this long-short strategy doesn't always involve shorting one stock and going long on another. Sometimes, you can short a stock and buy a broad market index future, essentially betting against the shorted stock and on the overall market.
For example, I could short "Lao Wang Milk Tea" and buy the S&P 500 index futures. Or, I could go long on "Lao Liu Milk Tea" and short the S&P 500 index futures. This is a common practice in hedge funds.
One of the most iconic figures in the world of long-short strategies is hedge fund legend Julian Robertson. His Tiger Management, founded in the 1980s, stuck to this strategy for 15 years, turning $8 million into $7 billion, a nearly 1000-fold return. In the 1990s, Robertson and Tiger Management were considered Wall Street royalty.
However, in 1995, with the rapid development of internet technology, many unprofitable internet companies went public. The US stock market entered a bull run. But Robertson, known for his conservative approach, believed these internet companies were overvalued. He started shorting them while buying value stocks as a hedge, essentially employing the long-short strategy we just discussed.
However, these internet companies continued to soar. Traditional valuation models failed to explain their valuations, so new models emerged, focusing on metrics like customer lifetime value and growth rates.
The internet industry was booming. Robertson faced not only losses from his short positions but also questions from investors who couldn't fathom shorting the future of the internet. Despite his conviction, Robertson couldn't withstand the market's relentless climb. Facing margin calls and investor withdrawals, his fund's AUM shrunk from $21 billion to $7 billion. In early 2000, Robertson, admitting defeat, closed Tiger Management.
Ironically, just six months later, the dot-com bubble burst. The relentless flow of funds into the market dried up, leading to a stock market crash. The Nasdaq index plummeted 75% in a year, and countless internet companies went bankrupt. Only then did people realize that the previous prosperity was a bubble.
Robertson was right, but timing is everything in the market. Some might say it was a huge mistake for him to exit before the bubble burst. Personally, I admire his ability to withstand the pressure for so long and his decision to step back when things seemed irrational. Ultimately, he preserved his legacy as a hedge fund legend. Predicting market direction is challenging enough; timing it is almost impossible.
Activist Short Selling: Exposing Fraud and Manipulation
Short-selling institutions know they can't just sit around, praying for the stock to fall. It's not a passive game. Our friend who shorted Tesla was vocal about his views, trying to convince the market that Tesla was overvalued. But even his efforts failed to move the needle. Why?
Because Tesla's performance was there for everyone to see. Arguments about valuation are subjective. It's a matter of perspective. Even Elon Musk tweeted that Tesla was overvalued, yet the stock continued to climb.
So, short-selling institutions developed a new tactic – publishing research reports.
These institutions would target companies engaged in financial fraud or deceptive practices. They would present their findings to the market, essentially saying, "Don't bother with valuations; the data itself is fake! It's all fabricated by management. The management is unethical."
In such cases, regardless of the company's valuation, fraudulent data is a serious red flag – an additional negative catalyst that guarantees a price drop. And that's when short sellers profit.
To convince the market, these institutions need to provide detailed and well-researched reports, not just a few pages of casual analysis. They need to present irrefutable evidence of fraudulent activities, often in lengthy documents spanning dozens of pages and thousands of words. Only then will the market take them seriously.
This might remind you of a famous company. You guessed it – Muddy Waters Research!
Muddy Waters' origins and short-selling philosophy stem from a chance encounter. Its founder, Carson Block, wasn't a finance guy but a law graduate who had experienced entrepreneurial failure in China.
In 2010, Block's father, a stockbroker, noticed a Chinese company called Orient Paper had listed on the US stock market through a reverse merger. Orient Paper's financials looked fantastic, with annual revenue exceeding $100 million. Excited about this discovery, Block Sr. wanted to buy a significant stake. He decided to send his 33-year-old son, Carson, to visit Orient Paper's factory in China, hoping to assess the situation and give his son some real-world experience.
Carson, perhaps inspired by Sherlock Holmes in his younger days, wanted to investigate discreetly. He contacted Orient Paper through an American journalist and pretended to be the journalist's Chinese interpreter. The duo then visited Orient Paper's factory, posing as foreign media.
What they found inside was shocking. Orient Paper's facilities were in shambles, a far cry from the picture painted by its financials. The factory equipment was from the 1990s.
Here's a picture they took inside Orient Paper's facility.
And here's a picture of a competitor's facility.
The difference was stark.
They also discovered that the $2.3 million worth of recycled cardboard claimed by Orient Paper was, in reality, a pile of rotting cardboard exposed to the elements. Furthermore, their financial analysis indicated that a company of Orient Paper's size should have hundreds of trucks moving in and out daily. Yet, all they saw was a single dirt road in front of the factory, barely wide enough for one truck. They waited for half an hour and only saw one truck, which could have easily been staged for their visit.
Carson knew his father had stumbled upon a disaster waiting to happen. He told him to hold off on the investment. Not only should they not invest in Orient Paper, they should short it.
And so they did.
At the end of June 2010, they released a 30-page report, exposing their findings. They alleged that Orient Paper had inflated its 2008 revenue by 27 times and its 2009 revenue by a staggering 40 times. They also disclosed their short position in the company.
Initially, the market reacted with a mild 10% drop. Orient Paper wasn't a major player, and Muddy Waters was relatively unknown. However, as media coverage intensified, the stock plummeted 50% in the next two days.
Facing scrutiny and questions, Muddy Waters released eight reports within a month, defending their findings. Over the next few years, Orient Paper's stock continued to decline.
This case put Carson Block and Muddy Waters on the map. They continued to operate in this manner, exposing and shorting companies like Rino International in November 2010, China MediaExpress in February 2011, Sino Forest in April 2011, and more recently, Luckin Coffee.
Their reports became increasingly detailed and professional, sticking to their tried and tested method – in-depth undercover investigations, followed by financial analysis. Once they identified a target, they would short the stock, release their report, watch the stock price crumble, and walk away with a profit.
Another short-selling firm, Hindenburg Research, follows a similar approach.
These research-driven short sellers are more like investigative firms than financial institutions. They scour the market for bad actors, aiming to expose fraud and protect investors. Their actions benefit honest companies that play by the rules.
However, they're not doing this solely for the greater good. As short-selling institutions, they aim to profit from their investigations.
Finding such blatant fraudulent companies is challenging. Carson Block himself stated that his ideal short targets share three characteristics, conveniently starting with the letter "L".
First, why "Large"? Because they need to be big enough to generate substantial profits. Spending countless hours on research and investigation only to make a meager profit from shorting a small company isn't worthwhile.
Second, why "Liquid"? Because high liquidity ensures that borrowing and selling shares is easy. As we discussed, borrowing shares comes at a cost, which depends on supply and demand. For companies like Apple, with a large shareholder base, borrowing costs are low, around 0.25% per year. For companies like Tesla, with high shorting demand, borrowing costs are higher, around 2.5%. During the GameStop short squeeze of early 2021, borrowing costs for GME shares skyrocketed to almost 80%, sometimes even exceeding 100%. This means even if the stock went to zero, short sellers wouldn't profit due to the exorbitant borrowing fees. Hence, Block emphasizes the importance of liquidity.
The third "L" stands for "Lying" – the presence of fraud. But finding fraudulent companies is no easy feat. It means being the first one globally to uncover the deception. As more short sellers and research firms enter the arena, finding such companies becomes increasingly difficult.
This presents a dilemma. Larger, more liquid companies are less likely to engage in fraud. This is why research-driven institutions like Muddy Waters have a limited number of short targets, often with modest market capitalizations.
According to Muddy Waters' filings with the SEC, their AUM is only $260 million, managed by a team of eight people. In the grand scheme of Wall Street, $260 million is peanuts. Yet, they're considered a prominent name in the short-selling world.
For institutions like Muddy Waters, with relatively small AUMs, targeting smaller companies shouldn't be an issue. But that's not always the case.
Often, you'll notice that Muddy Waters uses cautious language in their reports, saying things like "we have reason to suspect," "we seriously doubt," or "we have reason to believe." This is because they might not have concrete evidence.
Their short-selling campaigns against companies like New Oriental and Anta seemed speculative, lacking definitive proof. This vocal approach is often a necessity.
Their bark is bigger than their bite. Their actual market impact is minimal compared to their public persona.
Even prominent short sellers like Chanos manage funds worth around $10 billion, peaking at $60 billion – a drop in the ocean compared to Warren Buffett's $300 billion.
Roughly 3% to 5% of the US stock market is shorted. Most of it involves long-short strategies employed by funds like Tiger Management, not targeted short selling like Muddy Waters. This explains why Warren Buffett, when asked about short selling, said, "We don't short stocks."
Short selling, in its pure form, is a challenging game. Even seasoned investors like Buffett tend to avoid it.
Capital Attacks: The Big Guns of Short Selling
While purely short selling might not appeal to larger players, there's a form of short selling reserved for the big guns – capital attacks.
When these titans sense an asset bubble, they can deploy their vast resources to burst it. It's like rallying the market with a simple message – "Sell! Sell! Sell!"
They initiate a downward pressure on the asset price, creating a ripple effect. As others witness the price decline, they question their own assumptions, leading to further selling. If the feedback loop is strong enough, it can drag the asset price back to a more reasonable level, acting as a market correction mechanism.
However, this is all theoretical. In reality, markets are driven by emotions. It's impossible to achieve a perfectly rational correction. Panic selling and cascading effects can lead to market crashes and financial crises. This is why short selling is often frowned upon, particularly during times of economic uncertainty.
Two legendary figures exemplify the power of capital attacks: Jesse Livermore and George Soros.
Livermore, the "Boy Plunger," was a legendary short seller. In 1929, he orchestrated a massive short-selling attack on the US stock market through a network of over 100 brokers. The market couldn't withstand the selling pressure, leading to a historic crash and the Great Depression. Livermore profited immensely from this, earning over $100 million. However, he was also criticized for profiting from a national crisis.
Soros, the "Man Who Broke the Bank of England," is another iconic figure known for his short-selling prowess. His most famous trade was shorting the British pound in 1992. However, shorting currencies differs from shorting stocks. When shorting a currency pair, you're essentially going long on one currency and short on the other. It's a symmetrical relationship, unlike shorting stocks. Therefore, Soros' trade, while referred to as shorting the pound, was more of a pure capital attack than traditional short selling.
It's an intriguing story nonetheless.
Capital Counterattacks: The Fightback Against Short Sellers
Where there are capital attacks, there are counterattacks.
Short selling often faces strong resistance from those who benefit from rising stock prices. This includes:
- Shareholders and company management, who obviously prefer their stock to rise.
- Brokers and market makers, who profit from market activity, especially during bull markets.
- Media outlets, investment banks, and research firms, which are often incentivized to paint a rosy picture, either through direct payments or indirect benefits.
Short sellers, on the other hand, stand alone, facing immense pressure from those who want the stock to rise. To survive, they need either overwhelming capital or irrefutable evidence.
Let's look at a recent example of a high-stakes battle between a short seller and a powerful adversary.
In 2013, a hedge fund manager, let's call him "Mr. A," discovered a company called Herbalife Nutrition, a multi-level marketing (MLM) company selling health and wellness products. Mr. A was puzzled. Herbalife barely advertised, and few people seemed to know about them. Yet, they were generating $4.8 billion in annual sales.
His investigation revealed that Herbalife operated on a multi-level marketing model, where anyone could become an independent distributor. Distributors purchased products at a discount and earned commissions on sales. So far, so good. However, the line between MLM and pyramid schemes is blurry.
Mr. A concluded that Herbalife was, in fact, a pyramid scheme, profiting from its distributors rather than actual product sales. He decided to short the company, and not with a small sum. He initiated a $10 billion short position, equivalent to the combined AUM of four or five Muddy Waters.
As a prominent figure, his move sent shockwaves through the market. Herbalife's stock plunged 40%. Mr. A, following the short seller's playbook, launched a media blitz, spending tens of millions on reports and presentations. He even created a 300-page slideshow detailing Herbalife's alleged pyramid scheme. He believed that with him leading the charge and presenting solid evidence, the market would turn against Herbalife, regulatory agencies would intervene, and the company would crumble, leaving him with a hefty profit.
Enter Carl Icahn, the notorious corporate raider known for his hostile takeovers and restructuring of struggling companies. He saw an opportunity in Mr. A's short position. Icahn began aggressively buying Herbalife shares, single-handedly pushing the stock up 20% in a single day. He then launched his own media campaign, essentially calling Mr. A a fraud who was manipulating the market for personal gain.
The battle lines were drawn. Two billionaires, engaged in a war of words, with the market watching closely. Public sentiment seemed to favor Icahn, believing the narrative of a greedy hedge fund manager attacking a legitimate company. Herbalife's stock price, though volatile, trended upwards.
In 2014, the Federal Trade Commission (FTC) launched an investigation into Herbalife. Two years later, they fined Herbalife $200 million, ordered them to restructure their sales practices, and imposed other financial penalties.
It seemed like a victory for Mr. A. The FTC had taken action. But Icahn wasn't done. He continued to defend Herbalife, arguing that the FTC hadn't labeled them a pyramid scheme and that the fine was insignificant. Surprisingly, the market agreed. After a brief dip, Herbalife's stock soared, rising 51% in 2017.
For Mr. A, this was a nightmare scenario. Facing mounting losses, he was forced to cover his position, switching to put options instead. Herbalife's stock continued to climb, eventually forcing him to abandon his short thesis and exit the trade, incurring billions in losses.
This story highlights a crucial aspect of short selling – the short squeeze.
Short Squeeze: When Short Selling Backfires
Why would Icahn risk billions going head-to-head with a seasoned short seller like Mr. A? What if he lost?
While we can't know for sure, we can make educated guesses. It's highly likely that Icahn wouldn't have touched Herbalife if not for Mr. A's short position. He saw an opportunity in the short squeeze.
As we discussed, short selling involves borrowing shares, which requires margin. Mr. A's $10 billion position meant a massive margin requirement. Icahn realized that by aggressively buying Herbalife shares, he could drive the price up, forcing Mr. A to post more margin as his losses mounted. If the price continued to rise, Mr. A would eventually be unable to meet margin calls and be forced to cover his position, buying back Herbalife shares at a much higher price.
This forced buying would further propel the price upwards, creating a short squeeze. Icahn, being long on Herbalife, would profit handsomely from this scenario.
Even if Icahn couldn't deliver a knockout blow, he could drag out the battle, bleeding Mr. A dry. Remember, short selling involves borrowing costs, which accumulate over time. The longer the battle lasted, the more Mr. A would lose. Icahn, on the other hand, risked losing only his initial investment if Herbalife went to zero. However, a successful short squeeze would yield him significantly higher returns.
Interestingly, Icahn immediately resigned from Herbalife's board and sold his entire stake once Mr. A announced his exit. This suggests that he was never interested in Herbalife's long-term prospects. He was simply exploiting the situation for profit.
To understand how wild short squeezes can get, let's rewind to 1901.
Back then, two individuals were vying for control of a railroad company. We won't bother with their names or the company's name – they're not relevant to the story.
These two individuals began aggressively buying shares in the company in early 1901, driving the price from $20 to $130. Sensing an opportunity, several traders decided to short the stock, believing it to be overvalued.
However, the battle for control intensified, pushing the price even higher, to $150, $180, and eventually $200. Panicking, the short sellers decided to cover their positions but found no sellers in the market. The two individuals had bought every single share.
Desperation set in as short sellers scrambled for shares, driving the price even higher. From $200 to $300, then $500, then $800, and finally, an astronomical $1,000! Yet, they couldn't buy a single share. It was a short squeeze of epic proportions.
These short sellers faced massive losses, exceeding their initial margins. Brokers, unable to cover their clients' positions, began selling their other assets, triggering a cascade effect across the entire market. This, my friends, was the Panic of 1901.
Realizing the gravity of the situation, the two individuals decided to end their battle. They offered to sell their shares to the short sellers at $165, bringing the market back from the brink.
While lower than the peak of $1,000, the price of $165 was still high enough to inflict significant losses on the short sellers. They had become collateral damage in a battle between titans.
Similar short squeeze scenarios play out regularly in the market. While these market manipulations might seem thrilling, they create instability and distort rational pricing mechanisms.
For instance, some speculate that the final surge in the Nasdaq before the dot-com bubble burst was partly fueled by short squeezes targeting large short sellers like Julian Robertson.
The High Cost of Short Selling
We often hear stories of successful short sellers reaping massive profits. However, as we've seen today, short selling is fraught with risks and challenges:
- Limited profit potential and unlimited losses: You can only make as much as the stock price falls, but your losses are theoretically unlimited if the price rises.
- Limited short targets: Finding companies suitable for short selling is difficult, especially for larger funds.
- High borrowing costs: Borrowing shares can be expensive, especially for heavily shorted stocks.
- Resistance from companies and shareholders: Short sellers often face legal challenges and public relations nightmares.
- Short squeeze risk: Aggressive buying can trap short sellers, forcing them to cover their positions at much higher prices.
- Ethical considerations: Short selling is often perceived negatively, as profiting from a company's downfall can be seen as unethical.
Since 2021, the dynamics of short selling have evolved even further. The GameStop saga demonstrated the collective power of retail investors against Wall Street giants. Fueled by social media, these retail investors targeted heavily shorted stocks like AMC and GME, driving up their prices regardless of fundamentals. This resulted in billions of dollars in losses for hedge funds, marking a turning point in the battle between Wall Street and Main Street.
Short selling, while theoretically beneficial for market efficiency and price discovery, is far more complex and perilous in reality. The risks are substantial, and the ethical considerations add another layer of complexity. This is why many institutional investors, especially those managing pension funds and insurance assets, avoid short selling altogether.
These inherent challenges make for captivating stories, but they also highlight the high cost of short selling.