Three-line summary 📝
Short selling is an investment strategy where investors profit from an asset's price decline by borrowing and selling shares, then buying them back later at a lower price.
Tesla's recent share price drop has allowed hedge fund short sellers to gain significantly, despite past losses.
Short selling can improve market efficiency by highlighting overvalued assets and preventing price bubbles, though it carries risks and potential for manipulation.
The definition of ‘short position’ 💣
A short position or short selling an asset is an investment strategy where profit is generated if the value of the asset falls. Investors will first borrow shares of a stock they believe will decrease in value, then they sell those shares on the open market. They later buy back those shares at a lower price to return to the lender. Profit is generated between the sale and buyback price. Short selling is a risky strategy because if the stock price rises, then investors face large losses. Most often, investors pay interest when they borrow shares from brokers and the longer a short sale is out, the higher the interest costs. This is not an investment strategy for beginner or retail investors because it entails careful analysis and more information than what is available to the public.
What’s going on? 🤔
Tesla has lost half of its astronomical share prices and gains this year. Its fourth-quarter results announced in January failed to meet investor expectations. Furthermore, amidst falling car sales worldwide, Tesla warned that Trump’s trade war would make it one of the most vulnerable companies in the US. For example, JP Morgan lowered its projection of Tesla’s end-of-year target price to $120 from $135. Yet there’s a group of investors who have benefited off of Tesla’s fall from grace.
Hedge fund short sellers have made $16.2 billion from betting against Tesla’s shares. The number of Tesla shares being shorted went up 16.3% over the past month. This is equivalent to 71.5 million or 2.6% of Tesla’s total shares. In previous years, short sellers had been burnt egregiously from shorting Tesla shares. Tesla’s continued rally made a short position with Tesla’s shares a dangerous strategy since 2021. In fact, paper losses for short sellers amount to $64.5 billion since Tesla’s IPO (initial public offering) in 2010.
Yet what's important to note is that short sellers have maintained that Tesla’s valuation was quite possibly divorced from reality. Even as far back as 2020, short sellers stated that Tesla’s accounting methods were problematic, specifically that Tesla had failed to generate profit excluding the gains from zero-emissions tax credits that Tesla sold to rival carmakers. Of course, these remarks are from 2020, but they call into question the sustainability and reliability of investing in Tesla. Whether shorting Tesla is a good strategy in the long-term is a different question related to the reliability of Tesla’s share price and what it’s meant to reflect. JP Morgan noted that it’s never seen an automaker lose value at the rate Tesla has.
Paper loss means a loss in the value of an investment that appears in accounts. It does not involve a real loss of cash because it has not been realized.
Why is knowing this relevant? 🤩
As with the Tesla example, investors will sometimes express scepticism over the valuation of an asset. This relates to a positive function of short selling in the market. The price of an asset is determined by supply and demand dynamics and short sellers make this process more efficient by identifying assets that they consider overvalued and selling those assets. This puts downward pressure on prices. Ultimately, market efficiency is improved as asset prices are reflective of more realistic information. It can also prevent bubbles from unjustified price rises. Occasionally, however, investors have also been accused of manipulating prices by spreading negative rumors to profit from short selling. In some ways, short selling also creates an incentive for negative bias.