Selling short an essential part of efficient markets

Sainsburys and Asda confirmed on Monday morning the desire to merge their UK store base. They believe this merger will allow them to reduce prices by 10%, helping them, one assumes compete with the likes of Lidl. The food retail sector has been a favourite “short” of hedge fund managers as it appeared to face many structural issues. The latest being competition from Amazon. According to short tracker over 12% of Sainsbury’s stock was out on loan at the time the deal was announced. The hedge funds may have collected on the GKN deal, yesterday would have been more painful.

How does short selling work? The principal is to sell an asset at a price with the hope of buying it back in the future at a cheaper price. Only members of the London Stock Exchange can sell short. Non-members trade through members. A non-member sells short via a contract for difference with the member firm, then settle on the outcome.

The ability to sell short is fundamental to ensuring member firms can provide liquidity in market place, without it trading for member firms would be a great deal harder. Should a member firm sell short, either to facilitate a funds request or on his own account, the firm borrows the stock, generally from an institution, in exchange for an interest rate and then delivers the stock onto the buyer. The buyer receives his stock pays over the money and the trade is reversed once the position is covered.

A hedge fund business model is to be able to find relative value. Look at one company and conclude it is better value than another. It buys the company it likes and “shorts” the one it feels is less attractive there by negating the systemic risk.

Short sellers are not popular, they are often accused of forcing good companies into difficult positions as they can drive the equity price lower. We don’t sell short preferring to invest rather than trade on short term volatility. Short selling can be painful if you get it wrong, you constantly face margin calls if a price moves against you. You also face the possibility that the lender may look to either raise the borrowing costs or require you to return the stock which can force a closing of the position and crystallising a loss. Still it is an essential part of a well-functioning capital market.

Posted on May 1, 2018 .