Learning From Short-Sellers & Meme Stocks

No doubt you’ve seen the likes of Gamestop, Coinbase Global Inc, and other “meme” stocks in the news. But I bet you don’t know about the Solactive Roundhill Meme Stock Index. You read that correctly: there is now an index for meme stocks.

For most investors, meme stocks are a roller coaster of speculation that doesn’t make any sense. We do know that there are two sides to extreme volatility in the stock market. The meme stocks illustrate the rampant, speculative buying. Short-selling is the other side of the speculative coin and goes hand-in-hand with the trading activity of the meme stocks.

Or at least that’s what most investors believe.

Today, we’ll discuss why not all short selling is created equal. Not only that, but we’ll explain why this much-maligned strategy can provide valuable market intelligence if you know how to use it.

Although this affects stocks most directly, the principals apply to all asset classes.

The Mechanics of Short Selling

In my experience, few individual investors have sold a stock short. Most have a strong distaste for the concept. Ask them why, and the response is “people shouldn’t bet against the market”.  

But do they really believe that? To find out, let’s first understand how short-selling works. It may surprise you, and we’ll use a familiar example to get started.

When you press the gas pedal on a car (for this example we’ll assume it’s internal combustion), the car magically moves forward.

At least it appears that way. There is either a cable or electrical sensor that actuates the throttle body on the engine depending on how much throttle you give. That increases air flow to the engine, which is measured on the intake by a Mass Airflow Sensor. The sensor tells the car’s Electronic Control Unit, or ECU, to add the exact amount of gas to the combustion chamber needed and fire the spark plugs at the correct rate. That’s before the piston and connecting rods react to the combustion, spin the crank shaft, which is manipulated by the transmission, spins the driveshaft, and several steps later, rotate the car’s wheels. Then, and only then, does it “magically” move.

The practice of short selling is similar. It is borrowing the stock from an existing stockholder willing to lend it, paying an ongoing fee, netting out any dividend payments, and eventually buying the stock back from the lender to close out the trade.

The actual mechanics are a little complicated, but what you need to know is simple. Hit the gas and the car moves. Short sell the stock and the returns are the opposite of owning it. That’s it.

Can Short Sellers Really Manipulate Stocks?

Now, a common complaint about short selling is it can manipulate a stock downward. Let’s see if there is truth to this.

When you sell short 100 shares, it’s the same as a stockholder selling 100 shares they already owned. And we know that if everyone sells their stock in a company, that can cause the price to decline.

But there are a couple things to keep in mind. If someone tries to buy too many shares in a company all at once, we all intuitively know that won’t work. There won’t be enough sellers, and it’ll quickly drive the stock higher. As someone trying to get a good deal on the stock, that’s a problem.

The same applies to short selling. There is a limit to the number of shares available to sell, and every share sold short makes the price on the next trade less favorable. And the more shares sold short of a given company, the higher the rate is to borrow them. That naturally disincentivizes more short selling.

Companies with elevated levels of shares sold short have what’s called a high short interest. If 100,000 out of 1 million shares are sold short, the company has 10% short interest. As short interest climbs, so does the risk of a short squeeze. A short squeezes is not just an amusing term. They happen often, and have bankrupted many traders.

If a stock continues to climb, we know that short sellers’ losses mount. And unlike owners of stock who have a maximum loss of 100%, short sellers can have infinite losses. To exit their position, they have to buy the stock back from the lender. That buying puts upward pressure on the stock, and the painful cycle repeats.

That’s a real-life example of a famous short squeeze on Volkswagen stock. Notice that the forced buying by short sellers sent the stock from around 200 euros a share to 1,000 euros in a matter of days. Imagine the losses short sellers experienced. It’s no free lunch.

You may know of “naked” short selling. It’s the concept of short selling without borrowing shares, which can theoretically drive the price down of a stock unfairly. Naked short selling, however, is illegal per SEC Regulation SHO. It’s been that way since the Great Recession in 2008.

If you are a real investing nerd, you may have heard of “synthetic” short selling. That’s using options to take a position that mimics short selling without borrowing shares. While someone can hypothetically buy an unlimited of put options, for example, they don’t have any impact on the stock price as no shares are traded. And once again, there is a limit to how many options can be bought or sold since it’s a market just like stocks are.

Based on studies, there is little to no evidence of naked or synthetic short selling damaging markets.

That leads us to our next question.

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Is Short Selling Bad for the Market?

If you ask Yale professor Owen Lamont, who published an extensive study of 266 companies with high levels of short selling, the technique is a net positive. On average, companies targeted by short sellers significantly underperformed the broader market. Is that because short sellers drove down their stock prices or are other factors involved?

Mr. Lamont concluded that an unusually high number of companies targeted by short sellers were involved in fraud. Similarly, many were statistically overvalued and experienced price corrections only after short sellers made their cases.

As a result, one of his recommendations was “policy makers might want to consider making institutional and legal environments less hostile to short-sellers.”  

The key is to analyze arguments instead of focusing on who they are coming from. Many short sellers are highly experienced forensic accountants, and on average, are more informed about a company than its stockholders. If you own a company that’s “under attack” by short sellers, the research suggests it’s a good idea to consider their points.

In some cases, your opinion might differ. But in others, they are likely to teach you something you didn’t know about the company or its management team. Short sellers’ critiques are an excellent way to find potential weaknesses about a company that its management team is unlikely to publicize.

Conclusion

Thanks to short selling, the stock market allows investors with both bullish and bearish opinions to be heard. If you are like me, a lot of companies or investment opportunities aren’t attractive enough for my hard-earned dollars. That means we are all both long and short investors. We just may not choose to risk money betting against an investment we think is poor.

And if a company I own does have serious weaknesses I’m not aware, I’ll be the first to thank, not chastise, a short seller who brings them to light. This applies to all asset classes and investment strategies.

Short sellers can help bring balance to the markets. And if there was every an indication that was needed, it would be today’s meme stocks.

Before pulling the trigger on an any investment, it’s wise to consider the arguments against it. Short sellers provide that, and often in great detail. If comfortable with the points made by someone who disagrees with your investment thesis, odds are you’ve done your due diligence.

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