In light of the recent bullish (rising stock prices) market performance, one may be tempted to think that financiers across the world are celebrating the green-ness of their portfolios. But given the market’s notably poor performance just prior to this week’s rally, there’s every reason to expect investors to have loaded up on their short selling positions. In this article, we’re going to explore this rather enigmatic practice, its process, and how it's viewed by the broader community.
What it is
Put simply, short selling is an investment strategy where someone bets against a given asset - the more that asset decreases in value, the more money the investor makes. This immediately raises the question: why would anyone want to do this? One big reason is to hedge against (to protect oneself from something) the risk of losing money to another asset you’re currently holding. Say you have 10 shares of a company - no matter how strong their stock price seems, there’s still technically a chance it could go down.
In the event that the stock does drop, you may want some form of protection that could at least help you mitigate your losses. Here is where you could also purchase some shorts from the same company (we’ll go over exactly how this works in a minute), say 5 short positions, also purchased when the stock price was at $15. What this means is that if you bought those 10 shares at $15 each, and the stock price drops to $10, you’re not losing $5 per share - you’re only losing $2.5. Why? Because of your 5 short positions! If the total value of your share positions goes from $150 (10 shares * $15 each) to $100 (10 shares * $10 each), you’d ordinarily be losing $50. But the value of your short positions also change, and because shorting something means you’re betting against an asset (in this case, the stock), you gain money as the asset’s price declines.
5 short positions bought at $15 (totalling to $75), the stock is now $10, so each of those short positions have just gained $5, presenting a grand total of $25 in increased value. Subtract the share losses from these gains ($25 - $50) and end up with $25 in total losses, which divides up to losing $2.5 per share. You’ve still obviously lost money, but the point is your incurred losses are less than what they could have been had you not bought those short positions.
But if that’s the case, why not just purchase 10 short positions and then cover all your losses with the gains from those shorts? Because then while you technically wouldn’t be making any losses, you also won’t be profiting either - the losses from the short positions would “cancel out” so to speak the gains from the shares. Remember, shorting something means you gain money as the asset’s price declines. On the flip side, it means that you lose money as the asset’s price increases.
And this applies perfectly if we flip our example such that the stock goes up by $5. Without the shorts you’d be gaining $50 per share, but the shorts are declining in value by $5 each as the stock goes up, so you’re only gaining $25. That’s the real trade-off when using shorts to hedge your positions: you have to ask yourself how much money you’re willing to lose as well as how many gains you’re willing to forgo in the form of short position losses.
How it works
Contrary to activities like sports where all you need are 2 people to create bets for or against various outcomes, shorting a stock requires a slightly lengthier process to be done. Luckily, the process is quite simple.
In short selling, investors borrow some shares and sell them at the current market price If the price declines, they can repurchase the shares at the new price and then return them to the lender, profiting from the difference. So say you borrow 5 shares of a company and sell them at $15 each. Then the next day, the price of those shares decline $5 each. What you can do is buy them at the new, lowered price and then return those shares to the lender, effectively pocketing you $5 in profit per share. Essentially, borrow and sell high and buy and return low.
The controversy
Asides from being able to hedge one’s investment decisions, short selling also allows investors to profit in times of a recession as opposed to being limited to when the market goes up. Despite the variety of investment opportunities presented with this tool, there are some who despise its very existence. Some go as far to say that it should be illegal, arguing it’s a form of market manipulation especially seeing as how very few retail investors actually engage in the practice. In other words, it’s mostly large and influential investment firms that short companies, meaning if they publicly announce their short position, a bunch of other investors are going to follow suit, thereby driving the company’s price down.
Econ IRL
Most people associate the period between December 2019 and November 2021 as the rise and peak of COVID-19. But alongside it being one of the most significant pandemics in modern times, the time frame can also be marked by the jump in US housing prices, by 23.8% to be exact. What caused this rise? This week’s paper finds that it was in fact the shift to remote work that resulted in at least half of the aggregate price growth.
Using data on micro and metropolitan areas’ exposure to remote work (how likely it is that people in those areas are going to work virtually), the researchers find that each additional percentage point of pre-pandemic remote work implies a 1.97% growth in housing prices. But when looking at the growth of remote work during the pandemic, each additional percentage point resulted in a 1.47% growth in housing prices. After controlling for people migrating to and from various areas, however, the additional percent in remote work caused only a 0.93% growth in housing prices.
Lastly, the researchers noted that if the shift to remote work creates a broad increase in housing prices, then one should expect to see similar outcomes on rents. They find that the effects of remote work on rent growth are indeed very much akin to the effects on house prices. Additionally, greater exposure to remote work predicts a decline in commercial rents, which suggests a reduced demand for office space.
‘Till next time,
SoBasically