Latest / How Canadian Markets Work / Episode 10: Short Selling

Transcript

Episode 10: Short Selling · How Canadian Markets Work

0:00
Welcome, everyone. We are so glad you could join
0:02
us today. Today, we're going to gently unpack
0:04
a financial mechanism that, well, it honestly
0:07
sounds like a glitch in the very rules of reality.
0:10
It really does sound completely impossible when
0:12
you first hear it. It does. We were talking about
0:14
selling something you do not actually own. Yeah.
0:17
And intentionally taking on infinite mathematical
0:19
risk to do it. Which is just a terrifying concept
0:21
for anyone's portfolio. Exactly. So our source
0:24
material for today's deep dive comes from episode
0:27
10 of the financial series, How Canadian Markets
0:31
Work. It's hosted by John and Jane. And the episode
0:33
is titled simply short selling. Right. A very
0:36
straightforward title for a very complex topic.
0:39
Very. And our mission today. for you listening
0:41
is to really unpack John and Jane's insights
0:44
into the actual plumbing of this highly controversial,
0:48
entirely counterintuitive practice. We're going
0:50
to explore the punishing math behind the trade
0:52
and those hidden daily costs that just quietly
0:56
drain the account. Yeah. And we'll also look
0:58
at why short sellers might actually be you know,
1:01
the only people in the entire financial system
1:04
who are financially incentivized to look for
1:06
the truth. The mechanics are structurally brutal
1:08
for the retail investor, certainly, but the function
1:11
they serve in the broader market ecosystem is,
1:15
well, it's an absolute necessity. OK, let's unpack
1:18
this because I am honestly stuck on step one
1:20
here. That is completely fair. It's a lot to
1:22
wrap your head around. Like, I understand the
1:25
underlying concept of betting against the company.
1:27
I think we all get that. But physically, structurally,
1:31
How do you sell a stock you do not possess? Right,
1:34
it feels like magic. Yeah. I mean, who is legally
1:37
allowing you to hit sell on an entirely empty
1:39
brokerage account? Well, you cannot just hit
1:42
sell out of thin air. You have to find the physical
1:44
shares somewhere in the market plumbing first.
1:46
You know, you have to borrow them. Borrow them?
1:48
From who? Usually your broker is borrowing those
1:51
shares on your behalf from massive institutional
1:54
holders. So think of a giant state pension fund
1:57
or maybe a massive S &P 500 index fund. OK, so
2:00
the really big players. Exactly. They sit on
2:03
millions of shares of stock that they are planning
2:05
to hold for decades. But hang on a second. Just
2:09
logically, why would a pension fund who is holding
2:13
millions of shares of a specific company lend
2:16
those shares to a short seller? because the short
2:18
seller's goal is to tank the price. Right. Their
2:21
explicit goal is to destroy the value of that
2:24
exact asset. That seems, I mean, entirely self
2:28
-defeating for the pension fund. It definitely
2:29
looks that way on the surface. But you have to
2:31
look at the institutional incentives that John
2:34
explains in the source material. Okay, lay it
2:36
out for me. So if you are managing a passive
2:38
index fund, you cannot sell those shares anyway.
2:42
You are legally mandated to hold them to accurately
2:44
track the broader index. Oh, I see. So they're
2:46
just stuck with them. Right. Those shares are
2:48
basically just gathering dust in a digital vault.
2:51
So by lending them to short sellers, the fund
2:54
charges a borrow fee. It generates this nice
2:56
extra yield on an otherwise stagnant asset. Ah,
3:00
so it's a revenue stream for them. Exactly. Across
3:03
billions of dollars in holdings, those tiny little
3:07
fees add up to massive annual revenue for the
3:10
fund. And for them, that outweighs the temporary
3:13
price fluctuations caused by the short sellers.
3:16
Wow. OK, that actually makes the plumbing a lot
3:18
clearer. So to make this incredibly concrete
3:21
for you listening, it is like borrowing your
3:23
neighbor's lawnmower. I love this analogy. It's
3:26
just sitting in their garage. They aren't using
3:27
it. You borrow it. But instead of, you know,
3:30
cutting your grass, you immediately roll it down
3:33
the street and sell it at a yard sale for two
3:35
hundred dollars. And you just pocket that cash.
3:38
Right, you pocket the cash and then you sit there
3:40
on your porch sipping lemonade, just hoping you
3:43
could buy the exact same model of lawnmower on
3:46
clearance next week for $100 before your neighbor
3:49
asks for it back. The lawnmower analogy works
3:51
perfectly for the basic chronological sequence,
3:54
but here is where that analogy gently breaks
3:57
down in the real financial market. Oh, where
3:59
does this break down? When you borrow that lawnmower,
4:02
you do not owe your neighbor $200. You owe your
4:04
neighbor a lawnmower. Right. You owe them the
4:07
physical object, regardless of what it actually
4:09
costs you to acquire it later. Exactly. In the
4:12
financial markets, you now owe your lender shares,
4:15
not money. You have an absolute binding obligation
4:19
to return the exact number of shares you borrowed
4:21
at some point in the future. OK, so I owe shares,
4:24
not dollars. Right. And this is the mechanical
4:26
punchline. If the stock price falls, just as
4:30
you calmly predicted, you buy the shares back
4:33
in the open market for less than you sold them
4:35
for. You would turn the shares to the lender
4:37
and you keep that beautiful difference. Precisely.
4:40
But if the shares cost more to buy back, well,
4:42
you have to pay that difference out of your own
4:44
pocket. And that specific transition moving from
4:47
owing a fixed amount of money to owing a fixed
4:49
number of shares is where Jane's breakdown of
4:52
the math and the source material stops being
4:54
clever and starts getting genuinely vicious.
4:57
Vicious is the perfect word for it, because when
4:59
you owe shares instead of dollars, you entirely
5:01
invert the fundamental risk profile of investing.
5:04
Let's break that down for the listener, because
5:07
if I buy a stock normally, let's say I just invest
5:10
$10 ,000 into a company, my worst -case scenario
5:14
is structurally capped. Right, there is a floor
5:16
to your pain. Exactly. The company goes completely
5:19
bankrupt, the stock drops to zero, and I lose
5:21
my initial $10 ,000. Which is sad, but I cannot
5:25
lose $11 ,000. The loss stops at zero. But your
5:29
best case scenario is theoretically unlimited.
5:31
The stock could double. It could go up 10 times
5:34
in value. Right. My downside risk is finite and
5:36
my upside reward is infinite. But short selling
5:39
takes that mathematical reality and just flips
5:41
it entirely on its head. Your potential gains
5:44
are strictly capped and your potential losses
5:46
have absolutely no ceiling. Let's ground this
5:49
in the specific numerical example John and Jane
5:51
used because the speed at which these numbers
5:54
spiral out of control is just staggering. Let's
5:57
do the math. Imagine you short 1 ,000 shares
6:00
of a company at $50 a share. You borrow them,
6:03
you sell them, and you now have $50 ,000 in cash
6:06
sitting in your account. It's nice and simple.
6:08
And that $50 ,000 is your absolute maximum possible
6:13
gain. Right. Because the absolute best thing
6:15
that can happen to you is that the company is
6:18
exposed as a complete fraud, it goes bankrupt,
6:21
and the stock price drops to literally zero.
6:25
You buy back the shares for nothing. Exactly.
6:27
You return them and keep the $50 ,000. But what
6:30
if you were wrong? What if you wake up and the
6:33
company announces a massive new contract the
6:35
next morning and the stock price just rockets
6:39
up to $200 a share? Well, I still owe the institutional
6:42
lender $1 ,000 shares. Yes, you do. And to get
6:44
those $1 ,000 shares, you now have to go out
6:46
into the open market and buy them for $200 ,000.
6:49
Oh, wow. But you only made $50 ,000 on the initial
6:51
sale. That means you are down $150 ,000 on a
6:55
single trade. And the stock does not have to
6:58
stop at $200. It could go to $500. It could go
7:00
to $1 ,000. Which means my loss has no mathematical
7:04
ceiling. I am intentionally taking on an infinite
7:08
mathematical risk for a strictly finite reward.
7:11
What's fascinating here is that there is a psychological
7:13
layer to this structural asymmetry that Jane
7:16
highlights, too. Oh, the portfolio sizing thing.
7:19
Right. If I buy a stock normally and it drops
7:22
by 50 percent, my position size shrinks. It naturally
7:26
becomes a smaller part of my portfolio. My overall
7:29
risk is actually decreasing as I lose money.
7:32
That is such a crucial distinction. When a long
7:35
position goes against you, it naturally mitigates
7:38
its own damage to your portfolio. Exactly. But
7:41
when a short position goes against you, it grows
7:44
in size. As the stock price rises, the short
7:47
position consumes a larger and larger percentage
7:49
of your portfolio. Your risk increases exponentially
7:53
the more wrong you are. That sounds absolutely
7:55
terrifying. And the broker isn't just politely
7:57
waiting for you to figure it out, right? You
7:58
are operating in a margin account. Right. They
8:00
are watching you very closely. The broker requires
8:02
you to maintain a certain level of equity to
8:04
prove you can actually afford to buy the shares
8:06
back. So, as the stock price rises, your potential
8:10
loss grows and the broker demands that you deposit
8:12
more cash into your account immediately just
8:15
to keep the trade open. And that is the dreaded
8:17
margin call. The broker is just protecting themselves,
8:21
really, because if you blow up your account and
8:23
cannot afford to buy the shares back, the broker
8:25
is legally on the hook to return those shares
8:28
to the pension fund. They don't want that liability.
8:31
Not at all. So they will liquidate your other
8:33
assets without even asking your permission to
8:37
cover the debt. Here's where it gets really interesting.
8:39
Even if the stock price is just trading sideways,
8:43
doing absolutely nothing, the source material
8:45
points out that time itself is actively draining
8:48
your account. Time is definitely the enemy of
8:51
the short seller. Yeah, holding a short position
8:53
open requires paying continuous rent. It is a
8:56
slowly ticking clock driven by three specific,
8:59
somewhat hidden daily costs. First, remember
9:02
that borrow fee the pension fund charges. Right,
9:05
for lending you the shares. That fee is not fixed.
9:07
It is a variable rate based on supply and demand
9:10
in the market plumbing. For large stable companies
9:13
that annualized fee might be fractions of a percent
9:16
But if I'm trying to short a highly controversial
9:18
company that every other short seller is also
9:21
targeting Then those shares become what the industry
9:24
calls hard to borrow. The broker has to scramble
9:27
to find lenders willing to supply the shares.
9:30
And when supply dries up, that borrow fee can
9:33
spike to tens or even hundreds of percent annualized
9:36
seemingly overnight. Wow. So you are paying a
9:39
massive premium every single day just to keep
9:41
the position open. Yes. And the second cost is
9:44
margin interest, because you are holding collateral
9:47
in a margin account. But the third cost is the
9:49
one that I think completely violates normal investor
9:53
intuition. Dividend. The dividend rule is mechanically
9:57
necessary, but it is incredibly painful for the
9:59
short seller. So let's trace this. If I own a
10:02
stock normally, and the company pays a $1 dividend,
10:05
I just get a lovely cash deposit in my account.
10:07
Yeah, it's straightforward. But if I am short
10:10
1 ,000 shares of that stock, and the company
10:12
issues a $1 dividend, I have to pay it. Yes,
10:15
you do. I have to literally reach into my own
10:17
pocket, pull out $1 ,000 in cash, and hand it
10:20
to the original lender. Because the original
10:23
lender, let's say the pension fund, never actually
10:25
sold their shares. They merely lent them to you.
10:28
They are still legally entitled to receive any
10:31
economic benefits of ownership, and that includes
10:33
dividends. But since I sold their shares to someone
10:37
else. Right. Since you took their shares and
10:39
sold them to a third party in the open market,
10:42
the company is now paying the actual dividend
10:44
to that third party. The pension fund gets nothing
10:47
from the company directly. So you are legally
10:49
responsible for making the pension fund whole.
10:52
Exactly. So short sellers are bleeding out quietly
10:55
through borrow fees, margin interest and these
10:58
out of talk at dividend payments. And on top
11:00
of all of that, the general historical macroeconomic
11:04
drift of the stock market is upward. Right. The
11:07
market naturally wants to rise over time. Even
11:09
if a short seller is fundamentally correct about
11:11
a company, even if they know for a fact the business
11:13
model is deeply flawed. the weight might literally
11:17
bankrupt them before the market finally agrees
11:19
with them. Which brings us to the pressure cooker
11:21
environment. You have infinite upside risk, you
11:24
have continuous daily costs draining the account,
11:28
and you are operating on borrowed time. It's
11:30
a perfect storm. It really is. When you combine
11:33
all those structural elements, you create the
11:35
exact conditions for a short squeeze. What happens
11:38
mechanically in the plumbing when the market
11:41
decides to turn against a very crowded short
11:43
position? It is one of the most violent mechanical
11:46
reactions in the entire financial system. A short
11:49
squeeze is essentially an avalanche falling upward.
11:52
Let's just quietly trace the market plumbing
11:54
step by step here. OK, I'm with you. Imagine
11:57
a stock that is heavily shorted. A massive percentage
12:00
of the available shares have been borrowed and
12:02
sold. Everyone is betting the price will drop.
12:05
But suddenly, the company announces an unexpected
12:08
profit or maybe a revolutionary new product line.
12:11
the stock price starts to rise. Which means all
12:14
those short sellers are instantly under water
12:16
and their margin requirements are increasing.
12:19
Precisely. As the price creeps higher, some of
12:22
those short sellers hit their limit. They cannot
12:24
afford the margin calls anymore or their risk
12:27
management software just automatically triggers
12:29
an exit. How do they exit a short position? Well,
12:32
they have to buy the stock in the open market
12:34
to return the borrowed shares. They are forced
12:36
to buy. But what happens when a wave of buyers
12:40
suddenly enters the market with urgent, completely
12:43
price -insensitive demand? The increased buying
12:46
pressure drives the stock price even higher.
12:48
So their own forced buying pushes the price up
12:51
further. And when the price goes even higher,
12:53
a second wave of short sellers gets hit with
12:55
margin calls. Yes. Their brokers force them to
12:59
liquidate, which means they are now forced to
13:01
buy shares too. That drives the price up again,
13:04
which triggers a third wave of margin calls.
13:07
It is a pure mechanical feedback loop. Margin
13:09
calls trigger buying, which triggers higher prices,
13:12
which triggers more margin calls. Exactly. And
13:15
the buying isn't rational. They aren't buying
13:16
the stock because they suddenly think the company's
13:19
fundamentals are great. No, they're buying because
13:21
a computer at their brokerage is forcing them
13:24
to liquidate their position at any price necessary
13:28
to cover the debt before the broker takes a loss.
13:31
We saw the extreme version of this back in 2008
13:34
with Volkswagen. Hedge funds had massively shorted
13:37
the automaker, believing it was overvalued. But
13:40
then Porsche unexpectedly announced they had
13:42
secretly acquired a massive stake in Volkswagen.
13:45
Meaning there were very few shares actually available
13:48
to trade in the open market. Right. The supply
13:50
shares essentially vanished overnight. The short
13:53
sellers panicked. They rushed to buy back shares
13:56
to close their positions, but nobody was selling.
13:58
So all that demand hit a wall of zero supply.
14:01
Yes. The immense buying demand against a non
14:04
-existent supply caused Volkswagen's stock to
14:07
skyrocket so violently that for a brief moment
14:10
it became the most valuable company in the world
14:11
by market capitalization. Wow. It had absolutely
14:14
nothing to do with how many cars they were selling.
14:16
It was purely the plumbing of the short squeeze
14:18
breaking down. This is where Jane delivers a
14:20
really blunt reality check to the listener in
14:23
the source material regarding retail participation.
14:25
It is a very necessary warning. The structural
14:28
math makes short selling highly dangerous for
14:31
average investors, specifically because of forced
14:34
exit risks that you have absolutely no control
14:36
over. The margin call is the most common forced
14:39
exit where your broker liquidates you. But the
14:42
second risk is even more insidious and it is
14:45
entirely out of your hands. It is called buy
14:48
-in risk. Walk us through the plumbing of a buy
14:51
-in because this is kind of the ultimate trap
14:53
door. Remember, you borrowed those shares from
14:55
an institution. That institution retains the
14:59
right to recall their shares at any time. They
15:01
can simply notify your broker that they want
15:03
their shares back. And what happens then? Usually
15:06
your broker will just look for another institution
15:08
to borrow from behind the scenes and you will
15:09
never even know what happened. But what if the
15:11
stock is heavily shorted and literally no one
15:14
else is willing to lend? If the broker cannot
15:16
locate a new borrow, the settlement plumbing
15:19
forces a buy -in. You are forced to close your
15:22
position. You do not get a say in the matter.
15:25
So it doesn't matter what your investment thesis
15:26
is? Not at all. It doesn't matter if you know
15:29
for a fact the stock is going to crash next week.
15:32
You have to buy the shares today at today's market
15:34
price to give them back to the lender. It is
15:37
the ultimate tragic irony. You could do the deep
15:40
forensic research. You can be 100 % right that
15:44
a company is an absolute disaster, like a house
15:47
of cards waiting to fall. But you can still lose
15:49
your entire portfolio. Exactly. Because you couldn't
15:53
afford to survive the margin requirements of
15:55
the squeeze, or because your shares were recalled
15:58
just days before the collapse. You don't just
16:00
have to be right about the thesis, you have to
16:02
be right about the exact timing. And you have
16:04
to have deep enough pockets to survive the market's
16:06
irrationality in the meantime. As they say, the
16:10
market can remain irrational longer than you
16:12
can remain solvent. So hearing all of this, the
16:15
infinite mathematical risk, the daily drain of
16:18
borrow fees and dividends, the violent upward
16:21
avalanches of short squeezes, it honestly sounds
16:23
like a machine designed entirely to destroy wealth.
16:26
It does paint a bleak picture. Why do regulators
16:28
allow this to exist at all? I mean, corporate
16:32
management teams absolutely loathe short sellers
16:35
and they're widely despised by the general investing
16:38
public. Joe makes a very impartial defense of
16:41
the practice and the source material by stepping
16:44
back and looking at the broader incentive structure
16:46
of the entire financial market. What does he
16:49
mean by that? Well, the stock market is structurally
16:52
designed to be overwhelmingly positive. Everyone
16:55
in the ecosystem wants the line to go up. Precisely.
16:57
Corporate management is compensated with stock
16:59
options, so they are paid to make the stock price
17:02
go up. The analysts at investment banks face
17:04
immense pressure to issue buy ratings on companies
17:07
because their investment banking divisions want
17:09
to do lucrative underwriting business with those
17:12
same companies. Right. And regular retail investors
17:14
naturally want their retirement portfolios to
17:16
grow. The entire market is essentially a giant
17:19
cheerleading squad. Everyone is financially incentivized
17:23
to look at the bright side, to ignore the red
17:25
flags in the accounting, and to push asset prices
17:28
higher. Which means nobody is financially incentivized
17:31
to look for the rot in the floorboards. Nobody
17:33
except the short seller. Short sellers are the
17:36
only participants in the entire financial ecosystem
17:39
who actually make money by finding deeply buried
17:43
problems. So they are essentially the market's
17:46
immune system. If we connect this to the bigger
17:48
picture, yes, they absolutely are. Because they
17:51
only profit when a company's stock falls, they
17:54
are willing to spend millions of dollars doing
17:56
the incredibly tedious, deep, forensic accounting
18:00
work that nobody else wants to do. They're digging
18:02
through the fine print. Exactly. Historically,
18:05
short sellers have been the ones to expose massive
18:08
corporate frauds, fake accounting, and toxic
18:10
business models long before the regulatory agencies
18:14
or the general public ever caught on. Because
18:16
they have billions of dollars on the line, forcing
18:19
them to look closer. They provide the necessary
18:21
fiction that counterweight to all that relentless
18:23
corporate optimism. It is important to clarify,
18:26
though, that regulators do place heavy restrictions
18:28
on the plumbing of this practice to prevent abuse.
18:31
For instance, there is a concept called naked
18:33
short -selling. Which is when someone sells shares
18:36
without ever actually locating a lender to borrow
18:39
them from in the first place, right? Yes, they
18:41
are essentially selling phantom shares into the
18:43
market, hoping to find real ones later. That
18:46
practice is heavily restricted and closely monitored
18:49
by clearinghouses. So you can't just make them
18:51
up? No, the rules require brokers to officially
18:53
locate a borrow before they can execute the short
18:56
sale for a client. The system requires the physical
18:59
shares to actually exist and move through the
19:02
settlement plumbing. And Jane points out another
19:05
aspect of this that is actually quite useful
19:07
for you as a regular long -only investor, even
19:10
if you never short a stock in your entire life.
19:13
Right. The metric called short interest. Short
19:16
interest is a publicly available data point that
19:19
tells you exactly what percentage of a company's
19:22
total outstanding shares are currently sold short.
19:24
It serves as a fascinating dual signal for retail
19:27
investors. On one hand, if you look up a company
19:30
and see that it has a massive amount of short
19:32
interest, it is a very loud warning siren. It
19:35
tells you that highly informed institutional
19:37
funds with very deep pockets have done the math
19:41
and are willing to risk infinite losses because
19:44
they are so confident that this company is fundamentally
19:47
broken. It is a signal to do your homework very
19:51
carefully before you buy. But it cuts the exact
19:54
opposite way, too, doesn't it? A high short interest
19:57
also signals that the stock is a tightly coiled
20:00
spring in the market plumbing. Exactly, because
20:03
it is highly prone to a short squeeze. If any
20:05
good news comes out, all of those short sellers
20:08
are going to be hit with margin calls and forced
20:10
to buy, and the stock could explode upward. So
20:13
the short interest metric is pure information.
20:15
It warns you that the stock is going to be incredibly
20:18
volatile. regardless of which direction it ultimately
20:21
goes. Right. It's telling you to brace for impact
20:23
either way. So what does this all mean? Let's
20:26
gently summarize the mechanics we have unpacked
20:29
today. Short selling is a highly counterintuitive
20:31
transaction where you borrow shares from an institution
20:34
to sell them today, hoping to buy them back cheaper
20:36
tomorrow. And it is burdened by an inverted risk
20:39
structure. Your potential gains are strictly
20:42
capped at the initial sale price, but your potential
20:45
losses are mathematically infinite. It carries
20:48
heavy, continuous daily fees in the form of variable
20:51
borrow rates, margin interest, and those painful
20:54
out -of -pocket dividend reimbursements. And
20:56
you face the ever -present danger of violent
20:58
short squeezes and sudden buy -in risks that
21:01
can trigger automated liquidations. which can
21:03
wipe out your account even if your fundamental
21:06
research was completely accurate. Yet despite
21:08
being structurally punishing and practically
21:10
terrifying for the retail investor, it remains
21:13
a vital mechanism. It serves as a necessary counterweight
21:16
to market hype, incentivizing deep forensic research
21:19
and rooting out corporate fraud that might otherwise
21:22
go completely undetected by regulators. Which
21:24
leaves us with a fascinating, if somewhat unsettling,
21:28
adjacent thought to ponder. If short sellers
21:31
are essentially the immune system of the financial
21:33
markets, the only ones digging for hidden corporate
21:35
fraud, what happens to the overall health of
21:38
the economy if retail -driven short squeezes
21:41
make the practice so mathematically dangerous
21:44
that no one is willing to do it anymore? Oh,
21:46
that's a chilling thought. It is. Do we risk
21:49
entering a market where bad actors just go completely
21:52
unchecked because the immune system has been
21:54
neutralized by the crowd? It is a question of
21:57
whether collective market enthusiasm might accidentally
21:59
protect the very frauds we rely on short sellers
22:02
to expose. Yeah. Thank you so much for joining
22:05
us on this deep dive. We hope you feel more informed
22:07
about the invisible plumbing of the financial
22:09
system and perhaps a bit more cautious about
22:11
borrowing your neighbor's lawnmower. Keep questioning
22:14
the mechanics of the world around you and we
22:16
will see you next time.