Stop worrying about short sellers; love the lithium short squeeze

Buy low, sell high. Right?

Possibly, that is, if you think the price of the asset you’re interested in is going to rise.

This is the usual script most investors follow, but only because they’ve been trained by the mainstream media and the investment community to only think about investing in terms of buy and hold.

In reality, markets function very differently and far more efficiently. Professional investors – and to be fair, a growing number of retail investors – know that it’s possible to make money from both rising and falling prices.

There’s been somewhat of an awakening to the concept of short selling in recent years due. Perhaps the clearest example of this is the massive price appreciation of certain US stocks around the time of what has commonly come to be referred to as the “GameStop Fiasco”.

This is where retail investors banded together (spurred on by one Roaring Kitty!) to push prices higher and trigger a “short squeeze” in several beaten-down, old-economy companies like GameStop and cinema operator AMC. (You may wish to check out a really interesting movie called Dumb Money that was recently released. It investigates the events leading up to the GameStop fiasco and the subsequent fallout.)

To understand what a short squeeze is, you first need to understand shorting. If you’ve never considered it before, it can be a little confusing, so pay close attention.

The long and short of short selling

Firstly, just a reminder that the typical investment goes like this: Buy first, sell later.

We do this when we think the price of an asset is about to appreciate. If it does (that is, more than your transaction and holding costs), you’ll make a profit. If it doesn’t, you’ll make a loss.

Short selling just puts the buying and selling parts in the opposite order. We do this when we think the price of an asset is about to depreciate. That’s right, I’m sure you’ve been confident a stock is more likely to go down than up. Well, short selling allows you to take advantage of this scenario.

When we short, we sell first and buy later. I know what you’re thinking. How can I sell a stock I don’t own? You can’t. FYI, this is called “naked” short selling and is against ASX rules! To legally be able to short-sell on the ASX, you must first borrow the stock you wish to short from someone who is already a shareholder of the company.

In reality, this isn’t so easy to do by yourself. You’ll need to engage the services of a broker to help you set up a “stock borrowing facility”. That’s what brokers do best; they act as intermediaries between parties with different interests in the market. Your broker will handle all of the behind-the-scenes details and most likely charge you a fee for doing so (that’s also what brokers do best!).

The bottom line is when you type 100 shares into the quantity box on your order ticket, the next thing you want to do is hit the “SELL” button. Your broker knows you don’t own the stock, and automatically knows you want to go short. After you’ve hit the sell button, you’re short. There, you did it!

What happens now? Not much, really. The price of the stock will ebb and flow as it would have if you didn’t go short, and like any investment, it’s up to you when it’s time to get out.

Ideally, this occurs after the price of the stock has fallen. Remember, we want the price of the stock to go down when we short. If it goes up, we’re going to be facing a loss.

Either way, profit or loss, at some point you’ll have to hit the “BUY” button for the full amount of shares you’ve shorted to close your short. Closing a short trade is also known as “covering”.

As with any trade, the difference between your initial and final transaction price, minus your transaction and holding costs, determines your profit. It works like this:

• Let’s say we knew the Buy Now Pay Later craze was all hooey!

• On 1 December 2021, we decide to short Zip Co (ZIP) shares at $5

• We go to our broking platform, enter 100 shares in the quantity box, and hit the SELL button

• Our broker sees we don’t already own any ZIP shares and opens a short trade for 100 shares of ZIP on our behalf.

It turns out we were right, the BNPL craze was all hooey!

As it turns out, we were right, ZIP shares continued to tumble. While many ZIP shareholders were lamenting their tough luck, we’ve been rubbing our hands together, with each cent ZIP falls making us richer! When the ZIP price reaches $1, we decide to take our profit.

• We go to our broking platform, enter 100 shares in the quantity box, and hit the BUY button

• Our broker closes our short trade for 100 shares of ZIP and we have no further obligation

• Our profit is 100 x $5 - 100 x $1 = $400.

Note, if the price of ZIP went up to say, $10, in this case study we would have had to pay $1,000 to repurchase the ZIP shares, and therefore the result would have been a $500 loss.

Indeed, because there’s theoretically no limit on how high ZIP shares could go, there’s theoretically no limit to the potential loss in this short trade. This idea of potentially unlimited losses on a short trade is a key reason why short squeezes occur.

Squeeze those shorts!

A short squeeze can occur for two main reasons. The first is quite rare but has happened before: The original owners of a shorted stock call back their shares. The short seller is compelled to return the shares they’ve borrowed and typically has to buy at whatever price is available in the market.

Ultimately, though, short squeezes occur because the price of the asset in question starts to go back up. Remember, rising prices reduce the profits of short sellers, or put them in a loss. No investor likes losing out on profits or taking a loss.

So, a rising stock price can stimulate short sellers to cover. The buying from the shorts might be sufficient to push a stock’s price up and this might cause more short covering. It might even trigger some speculative buying from bottom fishers (and perhaps even those anticipating a short squeeze!).

A short squeeze occurs when short covering feeds on itself in a cascade of rising prices, more short covering, speculative buying, and ever-rising prices. It’s easy to contemplate a massive surge in a stock’s price due to a short squeeze in such a scenario, and that’s exactly what happened to GameStop.

The ASX experience: Lithium short squeeze, anyone?

No doubt, you’ve heard plenty of talk about a possible short squeeze in certain ASX lithium stocks, particularly Pilbara Minerals (ASX: PLS). I say “no doubt”, because you probably heard about it from us!

Each week, my learned colleague Kerry Sun publishes a list of the most shorted stocks on the ASX. You see, this is public information as all short sales must be disclosed, and the ASX publishes the full tally of short sales for each stock regularly.

It’s worth noting that Pilbara Minerals, along with several other major lithium stocks and battery minerals stocks such as Syrah Resources (ASX: SYR), Core Lithium (ASX: CXO), and Sayona Mining (ASX: SYA) are also heavily shorted.

Is the Pilbara Minerals chart the perfect short squeeze case study?

The question is: Is a short squeeze about to happen on beaten-down ASX lithium and battery minerals stocks? Many investors are speculating the process has already begun!

Short sellers aren’t good or bad, they just are

Many investors have come to loathe and perhaps even fear short sellers. In my opinion, they get a bad rap. Again, I believe this is because so many investors are tuned by default into thinking it's bad when share prices go down.

It’s only bad if you’re long. If you’re short, it’s great! Nobody is forced to hold any stock. Every investor is free to get out any time they please. Blaming the shorts for you choosing to hold a stock to oblivion is just passing the buck.

Short sellers are often active investors who do very good research to understand the true value of a stock. In the vast majority of cases, there’s a very good reason why a stock’s price is falling. In this way, short sellers aid in price discovery.

But, shorts are only one part of the supply equation. Regular selling from those piling out of an overpriced stock are also influential in pushing its price down. The other part of the equation is demand. A stock falls when the fundamentals are insufficient to attract cash into the stock at a particular price.

My point is the reason why a stock’s price is getting hammered isn’t solely because of short sellers. Also, when the shorts eventually have to cover back, they have to become part of demand. We never hear anyone complaining about that! I say all is fair in love and war, and all is fair in the markets. If you can’t beat the short sellers, then join them!

Double the opportunity

Which brings me to my conclusion – oh, and you’re welcome, by the way.

Now that you know how to short sell, you’ve effectively just doubled your investing opportunity. No longer do you have to watch from the sidelines a stock that you know is most likely to fall, do just that.

Even better, would be if you learned about a concept called “hedging”, which is where investors use strategic shorts to help reduce the risks of a major selloff in their portfolios. Hedging is important stuff for all investors to know about, but it’s also a topic for another day!