Short selling – or borrowing an asset in order to sell it with hopes of buying it back after the price has fallen – has been a part of the market psyche for years. You’re essentially selling a stock you never owned. The hope is that the stock price will soon plummet before you have to return those borrowed shares back to the dealer. That way, you can buy back shares cheaper than where you borrowed them, and pocket the difference, or your profit.
It’s a long established, yet controversial trading strategy that’s come under heavy scrutiny. Yet, regulators are poorly equipped to stop it.
Oftentimes, as we’ve seen with stocks, like NVIDIA (NVDA), short sellers will typically short the company first, and then release a thinly veiled report on why it could fail. Once the stock has successfully fallen on such a report, the short seller covers the initial short, collects the winnings, and walks away. It happens all the time.
In recent weeks, Citron Research went short NVDA, calling for the stock to fall to $90 on the idea that much of the company’s growth rate has come from gaming, and increased competition, which could damage gross margin sustainability. Other short sellers followed suit.
Unfortunately for them, the stock recently found support at $100 a share and has begun to run higher. In fact, analysts now have a $120 price target on the stock going forward. And the company just partnered with German automaker, Audi to bring autonomous cars to the market by 2020. And, on January 6, 2017, B. Riley, Needham, and UBS reiterated their buy ratings on the stock. Also, with further industry consolidation likely, coupled with the growth of the Internet of Things (IoT), upside appears to be unlimited for related stocks.
Traditionally, shorting a stock has been looked upon as unsavory and corrupt. Investors have gone as far as blaming short selling for the Crash of 1929. It got so out of hand, many countries, including the United States banned short selling of financial stocks during the crisis of 2008.
After all, there’s a reason we compare such traders to predatory animals. Often, shorts are willing to go to any length to make money, even if it brings harm to the most innocent of companies and its long-standing shareholders. In many negative cases of abuse, investors have argued that short sellers have an incentive to bring down a stock price with false allegations.
For example, Nobilis Health Corporation (HLTH) once fell victim to an aggressive short seller attack, plunging the stock from $5.72 to less than $2.70 a share. An anonymous Seeking Alpha article noted the company was severely overvalued. It implied the company had executive personnel issues and had issues with product failures, which did not exist. With such inflammatory accusations and misleading statements, the stock plummeted on volume of more than 4.6 million shares (about 10 times the three month average), closing the day down more than 25%. Short sellers won.
Shares of HLTH would eventually recover with patience, though.
In 2015, shares of chipmaker Ambarella (AMBA) stumbled 21% on 12 times normal volume after a short-seller site called the stock’s price “ridiculous,” noting that AMBA would lose half its value in a year. At the time, the stock had just risen 300% over the last year. It was sitting atop new highs in revenue, operating margins, net income and cash flow. It was on top of the world.
However, once the short sellers began labeling the stock as grossly overvalued, the stock began to slip. The argument was that investors had driven shares to an overbought valuation at a time when many high-definition video chips that AMBA makes were facing pricing pressure. A strong company was knocked off its pedestal. However, much like HLTH it is slowly recovering.
Bottom line with shorts – once the negativity has been priced in, the stock is likely to recover. Stocks like NVIDIA could easily rally to new all-time highs from here, too.