Short selling: What you need to know

The Adani Group has reportedly lost more than US$90 billion in value this week, thrusting short selling back into the spotlight.

Few activities in public markets attract as much attention as short selling. What is this controversial investment strategy, and what does it have to do with the fortunes of one of the world’s richest men?

Short selling is a trading strategy that allows investors to profit from a fall in the value of an asset. Rather than buying a stock you expect to rise in value, the basic position is that you are taking a bet against a stock. This is done by borrowing a stock from someone who owns it, selling it to someone else in the open market, then buying it back.

The expectation of the short seller is that the price of the stock will drop, thus allowing it to be repurchased at a lower price. Once the stock is repurchased, it is delivered back to the person who owns it – who earns a fee in this transaction for loaning out their stock – and the short seller pockets the profit.

Short sellers can be individuals or active fund managers, and shorting can take place in a variety of asset classes including equities, debt, and even cryptocurrencies.

In trading terms, the bet you make on a stock is called your position. To establish their position, short sellers post collateral, borrow the stock in a lending market, and pay a loan fee each day until they return the stock.

Short sellers face the possibility of:

• Margin calls if their position moves away from their expectation – in other words, their broker may demand more cash or collateral to cover potential losses
• Higher loan fees if the demand for shorted stock rises
• Loan recalls if the owners decide they want their stock back

Those thinking of shorting a security must also consider that they bear the risk of being caught in a ‘short squeeze’. This occurs when short sellers find it difficult to acquire the stock they need to close their short position. The shortage of supply can cause the price to rise dramatically, leading to significant economic loss for short sellers.

Two extreme and notable squeezes in recent history involved Volkswagen in 2008 and GameStop in January 2021. 

In the latter episode, a coordinated movement led by retail investors through an online community called r/WallStreetBets caused the price of GameStop stock to rise from $17 to a high of over $500 over a short period of time, devastating short sellers who experienced billions of dollars in combined losses.

Even though the practice of short selling has become more commonplace among individual investors, the strategy is mostly used by seasoned investors – particularly hedge fund managers and institutional investors.

Short sellers are generally regarded as savvy investors with exceptional information and processing skills which contributes to, on average, excess profits. They need strong market insight to correctly predict when a stock is over-performing and likely to drop in value.

Short sellers are controversial. They are viewed by some as noble activists making markets more efficient by rooting out fraud and wrongdoings, and deflating bubbles. Others see them as nefarious actors who manipulate markets and amplify price declines for personal greed.

Like most good tales, the answer is somewhere in the middle. Short sellers have been instrumental in uncovering and bringing to light major frauds from across the world including American energy giant Enron, German payment processer Wirecard, and Canadian pharmaceutical giant Valeant.

In many other instances, allegations by short sellers have only muddied the water causing short term bouts of market volatility. Listed Australian companies Wisetech and Lake Resources have both recently been targeted by short selling outfits with claims of accounting improprieties. 

A report published on January 24, 2023 by Hindenburg Research alleged accounting fraud and stock price manipulation over decades by Adani Group, triggering market panic and losses exceeding $90 billion in shareholder value.

The 106-page report accused the conglomerate of ‘pulling the largest con in corporate history’. It follows a follows a strategy commonly used by short selling activists, which is to detail a series of logical arguments and invoke doubts about senior management to develop a convincing narrative, then rely on investor emotions to see the stock value plummet.

The response from Adani has been swift, with the firm issuing a 408-page response accusing the activist of trying to ‘create a false market’ using unsubstantiated allegations to create a misleading narrative. The veracity of these claims will undoubtedly be investigated over time, and legal and regulatory investigations will likely follow, but whether these allegations will cause any longer-term harm to its stakeholders is at this moment uncertain.