Breakdown: What you need to know about short selling on the stock exchange and the associated risks

Acquires Multiple Financial Blog published transcript of an interview with the famous American financier John Hampton, in which he spoke about the risks associated with gambling and the use of short sales in stock exchange transactions. We have prepared an excerpt of the main ideas of this material – it will be useful for beginner exchange investors to familiarize themselves with it.

What problem are we talking about

Today, a fairly large number of speculators build their strategies around a “short game”. This means that such stock traders assume that the shares of a certain company or some assets should fall in price in the future.

To benefit from this strategy, they use so-called short selling – they borrow the shares of the desired company from a broker, sell them, wait for the price to fall, and then “buy back” them. The shares are returned to the broker and the speculator makes a profit.

Everything looks good as long as the plan works, and if the situation develops in the opposite direction, it is fraught with serious problems.

What could go wrong

Hampton explains the problem with an example:

Let’s say there are two gold mines. The capitalization of each of them is approximately $ 250 million, and it is believed that the reserves of gold in each is approximately 1 million ounces. It is planned to retrieve it in the period from 2024 to 2037.

There is indeed gold in one mine, and it is managed by a man who has devoted his whole life to work in this industry and the development of this deposit.

The second mine actually contains almost no gold, but is run by a man who is very resourceful, sells well and was able to convince everyone around that his deposit also has large reserves.

The surest way to know if we are faced with fraud, or at least serious violations, is to hire a professional geologist who can analyze the rock composition of the hill in which the alleged gold mine is located and the stream below it. If traces of gold are not found anywhere, then it will not be inside the mine either.

In such a situation, the head of a small hedge fund could set aside 5% of the finance to go short in the gold company that owns the mine. His goal is when the fraud is revealed and the stock price drops to zero, to earn that very 5%.

This is how events develop in 8 out of 10 cases, but it may be that the owner of the mine will say: “We actually found gold here, here is 10 ounces of proof.” There will always be a journalist who will describe this story beautifully, others will pick it up, and now the shares have grown 10 times.

Losses from 5% in a short position already become 50%, the fund’s capital is rapidly diminishing. And now the broker forcibly closes the position, because the client’s funds are no longer enough to cover the obligations on it. It turns out that even despite the fact that the fund manager was completely right about the shares of a particular company, and in the future their price will collapse, he will not have enough resources to wait for it.

Similar situations are faced by private investors who make assumptions about the prospects of stocks of varying degrees of validity.

How to deal with these situations

According to John Hampton, there are two ways to deal with these situations. The first and available to private exchange traders is not to invest significant funds in speculation with short sales, to allocate 0.1% of the capital.

The second is more suitable for companies and funds that can follow the path of the famous American speculator Carson Block. He is a professional short-run by founding a research company, Muddy Waters Research, which specializes in finding business irregularities and problems in Chinese listed companies.

Foundations can do this analysis themselves, or use the services of companies like Muddy Waters Research. And even in this case, they can only hope that they will be able to bring down the share price of a clearly overvalued company by 30-40%, as well as prepare for the possible consequences of a 5% short – if the strategy does not work right away.