Notes about short trading, and why Tesla is a dangerous short

Discussion in 'TSLA Investor's Corner' started by Spudley, Nov 6, 2018.

  1. Spudley

    Spudley Member

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    We all know about the short traders betting against Tesla and we all know about Musk's opinions about them.

    This post isn't about Tesla specifically though, but more about shorts in general.

    I'm not a seasoned trader, so my understanding of things is a bit simplistic. But the basic idea with a short trade is that you borrow shares from someone who owns them (probably an institutional investor), and then sell them hoping that the price will drop so that you can buy them back later at a lower cost. You can then give them back to the original owner you borrowed from with a profit in your pocket.

    Shorting is riskier than going long (ie buying the stocks) for two reasons: Firstly, you have to pay interest to the owner you borrowed from for the duration, which means that the longer you hold them, the less profit you make from the same price difference, and secondly the possible losses are theoretically unlimited if the share price rises; there's no limit to how high a share price can go, whereas for traders who own the shares, even in the worst case scenario of the company going bust, the possible losses are limited to the original purchase price of the shares.

    To prevent the problem of unlimited losses, short traders generally take the sensible precaution of setting an upper limit on the stock price at which point they they will buy the shares back even though it's at a loss because the losses would be too heavy if they held on and it went any higher.

    The phenomenon of a "short squeeze" occurs when the share price rises to that limit and forces some short sellers to buy back, which in turn pushes the price even higher and forces other short sellers to do the same, and so on. The result is a rapid increase in share price and massive losses for short traders. This can happen when a stock with a large number of shorts goes up in price to unexpected highs relatively quickly, often due to much better than expected financial results. Tesla shares have risen sharply over the last few weeks for exactly this reason and are close to triggering a short squeeze right now. It is possible that the squeeze may not occur yet as the price fluctuations in the short term are unpredictable and largely triggered by media coverage. But if it doesn't happen now, the squeeze is a virtual certainty if Tesla goes on to achieve another quarterly profit at the end of the year.

    Tesla is a particularly high risk stock to short because of it's historical volatility. This means that its price is known to fluctuate quite widely, which encourages short sellers to set a higher upper limit on the price than they might otherwise. While the stock is fluctuating, this is fine; it means that they can hold onto their short position even when the price goes up, in the expectation that it will come down again. However the flip side of this is the danger that the stock might not come back down again, in which case their losses will be much higher than they might have been.

    When a share has been sold short, it is technically owned twice. The original owner has only loaned it to the short seller so they still own it, but the new buyer also owns it. This means that shorting a stock actually increases the amount of shares available in that stock, albeit only temporarily.

    Another problem for short sellers that occurs during a squeeze is that they have to buy shares to exit their short position, but who will they buy from? If the stock is going up, who will want to sell?

    The amount of short sold Tesla stock is currently around 25% of its total value, which means there are more shares sold short than are owned in total by the largest share holder, Elon Musk, who holds around 22%. There are a number of other individuals with a lot of shares, as well as several institutional investors with large holdings. Together they account for over 60% of the stock. None of these share holders are likely to want to sell.

    Given those numbers, it isn't hard to imagine a scenario where the stock is rising, nobody wants to sell, and there simply aren't enough shares being sold for the shorts to be able to buy. This will push the price up even higher, and cause the short sellers even more losses. This is where a short squeeze turns into a short burn.

    Sensible short sellers will have used the money to they got when they sold the shares to buy other shares. This is called hedging (from 'hedging your bets'), and is where "hedge funds" get their name from. By doing this, you are protected from the short losses described above by rises in the price of the other shares you bought. When you close out your short position at a loss, you do so with money from selling the hedge shares you bought, and so it is possible to lose money with a short position but still come out in profit if the other share has done even better than the one you shorted. (This is why shares in companies like Amazon and Apple are heavily shorted; it's not so much that investors are betting they will lose value, more that the investors believe that they have already gone up as much as they can and have now reached a plateau, and that even if they do continue going up, they won't perform as well as other shares).

    However even hedging can't fully protect you against a really bad short burn: once the squeeze starts, you lose the protection of your maximum price limit on the short stock, because you can only buy them at the price that people are willing to sell; if the price shoots up past your cut-off price and continues to rise, then you will lose much more than you expected, and the value of your hedged shares is less likely to be able to make up the difference.
     

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