Selling Tesla ShortSubmitted by Headwater Investment Consulting on August 15th, 2018
By Kevin Chambers
Recently the financial news has been dominated by Elon Musk and Tesla. One of Musk’s biggest gripes about his company is the number of investors who are shorting it. Tesla is the most shorted stock in the history of the US Stock Exchange. So, I thought it would be a good time to remind all of us what a short sale is and how it works.
Traditionally, investors buy stocks because they believe the stock price is going to go up. This is also called going long. As the company does well, the price of the stock goes up which means investors could sell their shares at a higher price as stock increases in price. This is the basis for the buy-low-sell-high idiom. Investors look for companies that they believe are currently undervalued and expect the price to rise.
In short selling, an investor believes the stock price is going to fall. Basically, the exact opposite of the long position. They are betting against the success of the company. They believe that the market is overvaluing the company. Therefore, they will make money if the stock price falls. But how does that work? How do they make money from losses?
Pretend that Carl has 10 shares of stock in Tesla, which has a current price of around $340. Jane thinks that the company is going to be unsuccessful and that the stock price will fall. Jane wants to short Tesla. Jane goes to Carl and asks “Can I borrow your 10 shares of Tesla for 1 month? I’ll give you 5 dollars in interest for letting me borrow them.” Carl agrees and Jane takes the 10 shares and immediately sells them for $340 a share and pockets the $3,400. Jane was right about the Tesla’s management and the stock drops to $300 over the month. Jane buys back the stock for $300. All she owes Carl is 10 shares of stock, plus $5 interest, regardless of price. Jane and gives the 10 shares back to Carl and has made $395 in profit.
Short selling is considered very risky because your losses are in essence unlimited as the stock price rises. Short investors do not get any dividends or rights associated with their borrowed stock. Investors also usually have to pay periodic interest on their short position, so holding a position for a long time can be costly. Furthermore, you can be forced by the lender to return your borrowed stock. This is known as being called away, and the investor who shorted the stock has to buy back the shares at the current price. As a side note, this is what would happen if Tesla goes private. All of the short sellers would have to buy Tesla right away to get the shares back to their original owners.
Some of the risk associated with short selling, like picking individual stocks, can be mitigated by diversification. Some mutual funds use short selling to the lower the total risk of the portfolio by taking small short positions against some of their long positions. This will lessen the blow if that particular stock takes a big hit. Short selling can also add liquidity into markets. Headwater Investments would not take an individual short position but we do recommend some mutual funds that may take short positions. Although short selling is sometimes vilified, if used intelligently, it can be a powerful tool in portfolio management and market creation.