What Is Short-Selling And Why Does The DoJ Care: Analysis

Explainer: What is short-selling and why does the Department of Justice care?

A criminal inquiry into short-selling, a negative investment strategy, has been launched by the US Department of Justice.

According to three persons familiar with the situation, the Department of Justice has issued subpoenas as part of its investigation into hedge fund short-selling.

And their links with research firms that produce unfavorable assessments on specific companies.

Short-selling made headlines in 2021 as a slew of retail investors took to social media to rail against short-sellers’ lack of regulation and the destruction they may wreak on corporate prices.

They also utilized social media to enlist other investors in a quest to teach short-sellers a lesson by buying highly shorted equities.

SO WHAT IS SHORT SELLING?

Investors who’short’ a stock gamble on the price of the stock falling.
They borrow shares to sell right away, then wait for the price to drop before repurchasing the shares at a cheaper price.

When they return the shares to the lender, they keep the difference.

WHO LENDS OUT SHARES AND WHY DO THEY DO IT?

Borrowed shares might come from brokers’ inventories or from clients who give their shares to brokers to lend. The short seller pays the loan interest until the shares are returned. If the price rises rather than falls, the lender will be left with a more valuable stock.

WHAT IS SHORT-COVERING AND HOW DOES IT WORK?

When an investor sells borrowed shares, he or she must eventually buy them back and repay them to the lender. Short-covering is the act of buying back shares to cover or close a deal.

WHAT IS THE DIFFERENCE BETWEEN A SHORT SQUEEZE AND A LONG SQUEEZE?

An investor who sells shares short must be able to buy them back at a cheaper price in order to profit.

Short sellers may be forced to buy back shares at a higher price to prevent losses if the price of shorted shares rises.

A short squeeze occurs when there is a rush of demand from short sellers wanting to exit their positions, pushing rising stock prices even higher.

When the price of GameStop (GME.N) shares rose in late January as retail investors flocked in, some short-sellers, such as Melvin Capital, had to hustle to cover the shares they had sold short.

SHARE PRICE IMPACT OF SHORTING?

It’s difficult to tell how much of a day’s trading is due to short-covering or long-buying, which occurs when investors buy a stock in the hopes of seeing its price rise.

Short-covering, on the other hand, cannot adequately explain price movement if trading volume in a session substantially exceeds the number of shares shorted.

RISKS OF SHORT-SELLING

Because there is no limit to how high a stock price might soar, a short-seller could lose a lot of money. To cover their bet, they would have to pay the market price.

Stock availability is another danger for short-sellers, as they must return the same number of shares they borrowed, even if there are fewer on the market.

MIXED REPUTATION

By looking for weaknesses in a company’s operations and financials, some short-sellers have been able to foresee price drops. When they offer bad reports on equities they have shorted, however, they are frequently chastised.

After admitting to inaccuracies in an article that helped wipe $115 million off Farmland Partners Inc (FPI.Nmarket )’s value in 2018.

Quinton Mathews, who published research online under the pseudonym Rota Fortunae, reached a legal settlement in June to pay Farmland Partners Inc (FPI.N) “a multiple” of his profits from a bet against its shares.

Jim Chanos of Kynikos Associates, a long-time short seller, was vindicated for shorting now-defunct Enron Corp shares before accounting issues raised red flags on Wall Street in late 2001.

SHORT-SELLING: WHAT WE DON’T KNOW

Short-sellers are subject to significantly less regulatory monitoring than long-term investors, who are required to file quarterly filings with US regulators revealing a detailed overview of their stock holdings.

“Improved reporting of short sells would let authorities to better track these trends,” the Securities and Exchange Commission staff stated in an analysis of this year’s meme-stock frenzy. The SEC is now considering disclosure reform.