Elon Musk Tweets to Take Tesla Private and Short Sellers get Creamed – What Happened? Part 2 - Shor
You might have heard that Elon Musk tweeted about taking Telsa Private. That caused the stock to rise as expected. You might have also heard that he had been upset with “short sellers” and was very happy that they lost a lot of money after his announcement.
Here at Smart Invest Canada we try to take complicated financial concepts and explain them to the everyday investor. So, let’s use this news story to explain a couple of concepts – “taking a company private” and “short selling”. In our first blog post about this, we described what taking a company private means. In this installment, we’ll explain short selling.
Selling a stock short means selling a stock that you don’t have. Essentially, you borrow some stock and then sell it at the end of a period for a fixed price. If you are selling short you are betting that the price is going to drop over the period. So, if the price of the stock is $100 and you think it is going to go down to $90 in a week you sell the stock at $100 now and buy it back a week later for the lower price. If you are right, you make $10 on the transaction. If you are wrong and the stock appreciates then you have to pay the difference – for example, if the stock actually goes up to $110 then you’d have to come up with $20 to cover the gain. If the stock stays flat then theoretically you’d not lose or gain anything but practically there are costs to borrowing the stock to sell short (1-3%), so you only want to sell short if you are very sure the stock is going down.
Selling short is not for the fainthearted because although the gains are capped the losses are virtually unlimited. Plus, typically stocks are sold short on margin accounts meaning that the investor is only required to have a fraction of the value of the stock they are shorting in their account. If the stock increases significantly then the broker will come back to the investor looking for more money, in what’s called a “margin call”. There could be many margin calls if the stock continues appreciate.
So, let’s take the Tesla example of how things can go wrong for the short seller. On August 7, 2018 Musk tweeted that he is considering taking Tesla private for $420/share. On August 8, the stock jumped from about $340/share to about $380/share – a gain of about 10%. Let’s first consider the situation that might be more familiar. If the investor thought the stock was going to go up instead of down on August 6, they would have bought 100 shares of stock at $340/share = $34,000. If the stock did jump to $380 and the investor sold the shares for 100X$380 = $38,000 they would pocket a cool $4,000 on the transaction. While the buy transaction can also be on a margin account a short sale is always using a margin account and the investor is only required to have a fraction of the value of the stock in their margin account – this allows them to short sell more stock and increase their exposure, up or down.
Now let’s say you were a short seller who sold 100 shares short at $340/share on August 6. And we’ll assume that your brokerage is requiring 20% of the value of your short in your account = $6,800. When the stock jumps to $380/share, that 20% requirement jumps to $7,600 and the brokerage will ask you to add more to your account if necessary. This doesn’t seem too serious but things can really start to get tense if you’ve used the margin in your account to make a bigger bet. For example, let’s assume the investor had $34,000 in their account (the same amount that would have been spent to buy 100 shares of the stock). If they were required to have 20% of the value of the short in their account, then at $340/share, they could buy up to. 500 shares. Now, when the price increase happens, the cash requirement jumps to $38,000 and the investor will get a phone call, requested they put $4,000 in their account. If the price continues to rise then the margin calls keep coming.
To finish our example, let’s assume the investor gets out of their position at $380/share. With 500 shares they would have lost $20,000 plus the costs of the short. Since these short positions are always on margin, the relative losses (or gains) are always higher.
If we haven’t scared you away from short selling and you still wish to explore it further, you’ll definitely want the help of an investment professional. Get connected to one here.