Last time we looked at what short-selling is, and how hedge fund managers use prime brokers to borrow securities to sell short.
Jaeger, in his book, All About Hedge Funds: The East Way to Get Started, points out just how volatile short-selling can be. Suppose you open an account at a prime broker with $100,000 and sell short 1,000 shares in company A at $100 each. Your account now has total assets of $200,000 and a liability of $100,000, so your net equity is $100,000.
But let’s suppose the stock falls from $100 to $50 in value. Now your net liability (what you have to pay back to cover borrowing the stock) is only $50,000. This boosts the net equity in your account to $150,000. Then you buy stock in the open market, and pay back or “cover” your short. You are left with $150,000 in your account and no liabilities. You successfully shorted high and covered low.
But the opposite can also happen. If the stock rises to $120 a share, your liability goes up to $120,000. That means the net equity in your account is only $80,000. If the stock continues to rise, it keeps increasing your liability, to the point where your prime broker may be worried about your ability to repay the stock. This leads to the well publicized “margin call”, where the broker wants you to put more money in your account as collateral. If you do not put more money in, the broker may force you to cover the short position at whatever the market price is.
Jaeger points out two other troublesome aspects of short-selling. The first is that short sellers have limited upside potential on their investment but unlimited downside risk. This is the opposite of a long position. In a short position, the best that can happen is a stock falls from its starting point, say $100, down to $0. You would reap a handsome profit from that. However, the potential exists that the stock could appreciate to $200, $500, or even further. Increasing your losses exponentially.
The second troubling aspect of short-selling is that your mistakes become a larger portion of your portfolio. Here’s how Jaeger explains it. Suppose you had a $1,000,000 portfolio with 9 long positions of $100,000 each and one short position of $100,000. If one of your long positions drops by 50%, your portfolio would be worth $950,000. The losing position would represent only 5.3% of your portfolio, instead of the original 10%. So any further losses in that particular stock would have less of an impact.
However, if your short position were to rise from $100,000 to $150,000, you would once again be out $50,000. Your portfolio would be worth $950,000, as before. But the out-of-control short position would represent 15.8% of your total portfolio. So your mistakes in short-selling tend to get “amplified” versus making mistakes with a long position. They have a bigger and bigger impact on your total portfolio.
That could explain why Jaeger says hedge fund managers watch their short positions “with a vigilance that borders on paranoia.”
In addition, since shorting involves borrowing, it carries the risk of a margin call just like leveraged buying of long positions. Or, if the lender of the original stock wants it back right away, the short seller may also be forced to borrow from someone else or sell at a disadvantageous position. This is referred to as a “short squeeze.”
Despite all these risks, short-selling is an important part of the hedge fund world. As we’ve discussed in our article on market-neutral strategies, short selling enables hedge fund managers to hedge market risk out of the investment equation, and focus on the behavior of promising securities instead.
Jaeger, Robert A., All About Hedge Funds: The East Way to Get Started. McGraw-Hill.
Logue, Ann C., Hedge Funds for Dummies. Wiley Publishing Inc.