Stock Commentary

Overview of short selling and how retail can (maybe) participate

Merkado Barkada

October 27, 2023 | 8:30am

Overview of short selling and how retail can (maybe) participate

Short selling is coming to the PSE on November 6, so considering how slow and uninteresting the PSE is right now, I figured it was a good enough time to talk about how short selling works, who might find it useful, and how we small-timers might be able to participate in this new order type. I’m going to start a the beginning, so if you understand how shorting works, maybe skip past the first couple of bullet points.

> What is short selling?  Short selling is an order type where the seller borrows a stock from someone who already owns it, sells that stock to another person, and then (at some point) buys back the stock at (hopefully) a lower price to give back to the first person they borrowed the stock from. When a trader buys a stock in a traditional stock buy transaction (goes long), they’re hoping that the price of the stock will increase so that when they sell the stock at some point in the future, they’ll have made a profit. With short selling, a trader sells the stock (goes short) and hopes the price of the stock will decrease so that when they buy the stock back at some point in the future (covering the short position), they’ll have made a profit.

> Is short selling risky?  Yes, short selling exposes the seller to the potential for infinite losses, while also exposing the seller to borrowing costs to maintain the position. If you buy a stock normally, say P10,000 for 1000 shares of Fake Example Company (FEC), the most that you could lose if FEC completely blew up and died would be the P10,000 that you used to make the purchase. Your potential gains are theoretically unlimited, as it’s possible for FEC to grow and grow indefinitely. Regular buys expose you to a fixed amount of risk (how much you paid) and an unlimited amount of potential upside. Now, if instead, you decided to short FEC by borrowing 1000 FEC shares and selling those shares into the market for P10,000, that’s when things get different. Your absolute best potential outcome is for FEC to blow up and die, and if it did, you would stand to gain the full amount of the value of the shares that you sold (P10,000). But what happens if FEC decides to pump? Well, if FEC doubles in price you will have suffered a 100% loss, as it would cost you ?20,000 to buy back the shares to cover the short position. If it triples in price, you will have suffered a 200% loss, as it would cost you P30,000 to buy back those same shares. Theoretically, your upside is capped at the amount that you sold the shares for, and you have an unlimited amount of potential downside risk. Of course, there are several control mechanisms that should prevent a situation where a retail trader could end up owing several multiples of the value of the stocks that they sold, but from a theoretical perspective, the potential losses on a short sale are infinite.

> How do people use short selling?  Most of the people that I know who use short selling in international markets use it to hedge a long position. Some use it as a way to take advantage of arbitrage opportunities around potential mergers. Very few people in my investing circle use shorting as a directional trading strategy, where they scan the market looking for great short opportunities and pick shorts like one of us would scan the market and pick longs.

> What shares can we short?  Shorting is limited to companies that are part of the PSEi, as well as companies that are part of the MidCap and DivY indices. There is also a short-selling limit of 10% of outstanding shares that is calculated on a per-company basis.

> So can retail take part?  Yes, and in a couple of different ways. Long-term retail investors who own stocks that are eligible for short selling can earn additional income through lending fees by lending their stocks to other investors who want to short sell. It’s also possible for retail investors to participate in short selling, though retail investors are not able to participate directly. You will need to short-sell through your broker. In either case, whether you want to lend your shares or sell short, you should contact your broker. For retail investors, the broker is the necessary intermediary.

> Will all brokers allow short selling by retail investors?  Participation in the short-selling program is not mandatory for brokers, in that brokers do not need to offer this service to clients to maintain their broker’s license. Even if your broker is a part of the program, it is up to the broker’s discretion whether or not they will allow a particular retail trader to use the short-selling program. Remember that retail traders do not have direct access to the short-selling program, so we will need a broker to hold our hand through everything that we do within the shorting ecosystem.

> Will the GStocks integration allow short selling?  No, not initially, though the PSE said that this is something that the GStocks group plans to explore in the future.

> What happens if I lend shares and dividends are declared on those shares?  During the loan term, the lender (the original owner) of the stock will keep all of the stock’s economic benefits. So if you lend FEC shares to a short seller, and then FEC declares dividends, you will be the person who will receive the dividends.

> If I lend my shares, can I get them back at any time?  Yes, it appears as though the PSE has put a lot of thought into making sure that lenders can recall their shares at any time, while not affecting the short seller’s position. The PSE said that brokers should be able to do the legwork behind the scenes to identify additional shares from another potential lender to maintain the open short position while allowing the original lender to recall their shares. The PSE said that recalls should occur within the regular settlement cycle (T+2). If you recall the stock on Tuesday, you should receive the stock on Thursday.

MB bottom-line: I know it’s tempting to look at the market and see an endless menu of potential short candidates, but in reality, it’s really just as hard to pick a stock that will go down as it is to pick a stock that will go up. If you are struggling to make a profit in picking price appreciation winners, the same limitations will likely apply to cause you to struggle at selecting price depreciation winners. It’s not an easy game, and things can go wrong very quickly if something happens that is unexpected like a surprise tender offer announcement. At least when you’re long and the market sucks, all you have to do is ignore all the red in your portfolio while you go about your regular day. When you’re short and the market moves against you... well, nothing feels quite as bad as a margin call. That’s the worst feeling that I’ve ever had in trading.

At the end of the day, I think that short selling is going to be more of a spectator sport for 99% of retail investors. It will be fun to watch the early reports to see which stocks have the heaviest short interests, and to watch how those short interests change over time due to shifts in news and information. If you’re interested in short selling or have experience with shorting from trading in international markets, your best bet is to talk to your broker as soon as possible to see whether they’re participating in the short selling program, and to see if you qualify to take part.

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