Understanding Short Sellers
What is a short seller? A short seller is an investor or trader that makes money from a stock or the market going down. At times they get a bad rep, but they are a needed player in the markets. Although this is a website dedicated to long-term fundamental investing, we think it's important to understand short-sellers.
How Does an Investor Make Money When a Stock or The Market Goes Down?
The answer is by short selling a stock or an ETF. The process of shorting allows an investor to borrow shares from their broker and sell those shares in the market. The short seller makes a profit when the share price of the stock declines. The short seller will purchase or cover the shares at a lower price. The gap between the price at which they sold the shares and the price they bought the shares back is where the profit is. If a short seller shorts a stock at $25 per share and covers at $15 per share, the short seller has made $10 in profit.
How Do Short Sellers Operate?
To be a good short seller there has to be an understanding of fundamental analysis and the supporting story.
1. Fundament Analysis: Good short sellers, do their homework. They understand what a well run company looks like, and because of this it is easy for a short seller to spot a company that is not operating the way it should.
2. Understanding the Story: Understanding the story of a company's stock or the overall market ties in with the fundamental analysis aspect of short selling. There are times when a company's story resonates with investors more than the company's or the market's fundamentals. Investors will continue to buy a stock because they love the story, and they will ignore the fundamentals. Professional short sellers are great at identifying these situations and taking advantage when the story surrounding the company or the market no longer holds up.
Why Does Wall Street Hate The Big Short Sellers?
Because naturally we want stocks to go up in price whether the company is sound or not; but short sellers represent a population of market participants hoping the stock goes down. No one likes to be rooted against, and in essence that is what short sellers are doing. Also the more famous short sellers hold a level of influence over the market that can really impact a stock price. A company like Citron can influence a stock price with a tweet. The CEO of a company on Citron’s short list could find themselves answering unwanted questions about Citron's analysis, instead of tending to the business they are paid to manage. It's not a spotlight any CEO wants to be in.
What Can Long Investors Learn From Short Sellers?
1. Know the business you’re invested in. Good short sellers are thorough in their research. Be sure that you are investing with the same information the short sellers are using to make their short positions.
2. Don't ignore an increasing short position. If your invested in a company and the short position increases over a period of time, don’t ignore this. Review your research, make sure your reasons for investing in the company are still sound. If not, exit the investment.
3. Learn to separate the story from the fundamentals. A good company doesn’t equal a good stock. The promise of change and innovation doesn’t guarantee a winning stock either. Be sure as an investor that whatever a company's story, the company has the fundamentals to support the story. During the dotcom era there were a lot of companies with industry changing, sector changing, or world changing ideas. However those companies had bad management, bad finances, and bad business practices. The dotcom bubble burst was the haze of these company’s story wearing off, and the reality of the fundamentals coming into focus.
As an investor, novice or experienced, try to keep an eye out and an ear open for any short positions building in a company you are invested in. If short sellers are eyeing one of your investments, make sure you are working with the same information that the short sellers are using. If you find that the fundamentals that you’ve based your investment on have changed, and that change favors the short sellers, don’t be afraid to exit your position. Also keep an eye on the story surrounding your investment, if it has a story. Verify that the story is supported by the fundamentals, if not, be prepared to exit the investment.
Now that you have an understanding of short sellers and how short selling works, you’ll be better prepared as an investor.
View analysis from a well know short seller here.