Business

Short sellers face the rage of an army of small traders

January 31, 2021

Few tears are being shed for the hedge funds that were humbled by an army of retail investors in a wild week of trading on Wall Street.

Sometimes maligned as predators, these short selling funds have now become a target for the rage of small traders, who — on social media sites such as Reddit — have painted them as members of an elite stacking the odds against the individual investor.

One such fund even threw in the towel on Friday. After 20 years in the shorting business, Citron Research said it would no longer publish reports identifying stocks to sell and would now focus on identifying opportunities to buy.

Along with Melvin Capital, it had been one of the hedge funds caught out by a wildfire of buying among retail traders, mainly focused on the shares of struggling retailer GameStop. Their buying and the resultant share price rise forced the hedge funds to close their bets on price falls, at painful losses.

However, in such febrile times, it is important to remember that short sellers play an important role in the financial ecosystem.

Short selling is a bedrock trading strategy deployed by hedge funds. It involves borrowing shares from a brokerage and then selling them in the market, with the aim of buying them back at a lower price before returning them — thereby generating a profit.

When it happens, it provides a warning to long-term investors about lofty valuations and identifies companies with troubled business models. In turn, it helps hold management to account and, in some cases, shines a light on suspicious accounting.

Hedge funds short selling shares in Wirecard, for example, copped plenty of opprobrium but were proved right when Germany’s fintech darling collapsed into bankruptcy last year.

Deploying a so-called long/short strategy — whereby troubled companies are sold and stronger rivals bought — was rewarding for hedge funds in 2020. It delivered an average gain of 17.3 per cent according to Eureka Hedge, a data provider.

But another reason people don’t like short selling is that it challenges a powerful equity market narrative of optimism in the long-term growth prospects of companies — and steadily rising share prices over time.

Such bullishness courses through the postings on platforms such as Reddit's r/WallStreetBets, which helped drive shares GameStop into the stratosphere.

These traders might not have been entirely the amateur army that is suggested in some quarters. Professional traders have personal accounts, too. But there is no doubt there has been a boom in US retail trading, boosted by stimulus cheques, cuts in brokerage commissions and the ability to buy fractions of shares.

The weapon of choice for the new collective of retail investors is the option to buy shares at a set price — offering a “lottery ticket” or a “sports betting” approach to trading.

Buying such a “call” option for a modest upfront premium represents the limit of their exposure. However, the upside from a call option appreciating in value can be great.

These options have given retail investors the clout to challenge the hedge funds, some of which made themselves more vulnerable by pushing the envelope too far, particularly in the case of GameStop.

The number of GameStop shares that short sellers had sold and promised to deliver to buyers was equivalent to 260 per cent of the shares in existence, according to Morningstar. Unwinding some of that heavy bet explains how shares in GameStop at one point surged towards $500 a share this week after trading around $20 earlier this month.

“Once a stock is heavily shorted, you are putting yourself in a position where you are no longer in control,” said Brad Lamensdorf, a long/short hedge fund trader who runs Active Alts. “Everyone can see that it has become a crowded position and vulnerable to a reversal.”

The majority of investors with diversified portfolios will look past this market noise. But, clearly, there are areas of the market that are trading well out of line with notions of fundamental value. This will provide opportunities for investors beyond a day-trading mindset.

Stocks such as GameStop are ripe for falling back to earth, rewarding short sellers at some point. Other shares knocked by forced sales from hedge funds that needed quick cash to cover their losses will provide a buying opportunity.

“The fact that there is more mispricing implies more return opportunities for the patient contrarian investors,” said Vitali Kalesnik, partner at Research Affiliates.

However, the current market dynamic — a speculative surge from retail investors using borrowed money and derivatives — has in the past signalled a frothy market top. Similar peaks, notably in 2000 and to a lesser extent in 2007, were followed by big declines that registered broadly — not just among a few chastened hedge funds.

“One of the surest signs that a bubble is close to bursting is when the retail investor piles in with leverage,” noted Albert Edwards at Société Générale. “And if the retail warrior millennial mob are angry now, wait until they lose their shirts in any market collapse.”