It would appear pertinent at this point to go over some of the principles of shorting. In this case specifically when the short seller intends to back the short by exercising the shares of a warrant holder. They may be two separate parties, or indeed the same – as there is in principle nothing to stop warrants being sold, like any financial instrument, to another party.
In some territories shorting itself is not permitted, in others it is with restrictions – this article should not be taken as a legal opinion and is most certainly not a recommendation to short – it is merely provided here to readers of the Bushveld Perspective as explanation of the shorting strategies that warrant holders may employ when the company share price is greater than the strike price of the warrants (so-called ‘in the money’).
Imagine, for a moment, that a shorter, let us call them Mr X, has a block of warrants, say N in number, at a strike price, S. Imagine also that the share price, P of the company in question has risen above the warrant strike price – as shown below.
What can the shorter do – the answer as usual is in the question – Mr X decides to sell all, or let’s be a bit more general here – a fraction f (f=0 is 0%, f=1 is 100%), of the N shares that he holds warrants for.
Readers might object on the basis that the warranted shares have not be created yet, and therefore cannot be ‘borrowed’ to short against – however this analysis yields exactly the same results if the shorter already has a long position of N (or more) shares, and the nett shorts described here are merely the selling of all or part of that holding – all sells and buys, and profits made, are identical whether the short be a real one, or a just a nett one with respect to a baseline holding of N (or more) shares. If the shorter does not completely destroy the long term prospects for the company then the value of the baseline holding of N shares is unaffected long term.
Back to the story – Mr X sells f.N shares into the market in an aggressive fashion – the share price drops, and he gets an average price indicated by the small red dot on the graph below.
What happens next depends upon what the share price does.
Scenario 1 – Share Price Recovers
In a market with strong underlying investor sentiment, say a mining company that has recently had huge rises in the sale price of the commodity that it produces – the market may quickly recover after the rapid selling activity.
Clearly Mr X misjudged the situation – the shares he sold in the initial burst were all bought by genuine investors who profited by getting shares at much lower prices than they would otherwise have got. Shorting the stock is not a good strategy because Mr X is not going to be able to buy any shares back to close the short at a lower cost than he just sold them for.
Looks like he will have to make use of the warrants – so he sells the remaining (1-f).N shares, this time more slowly and once the SP has recovered. He gets a slightly higher price for the second block of shares so he still gets enough cash to pay for the warrants when he exercises them – but it is not as much as it would have been had he sold all the warranted shares into the market slowly. In this scenario Mr X would ideally like the fraction, f, that he sells fast in the first block, to be small – ideally less than 0.3 (30%), to optimise his profit.
Scenario 2 – Share price crashes
Mr X might be able to convince himself that scenario 1 was a win, of sorts, but of course what he really wanted was for the market to be much more seriously perturbed by his actions. He might have hoped that his aggressive selling had uncovered some high-lying Stop-Loss instructions so that he could pick up some shares on the cheap, or even kick off a complete market panic – ohhh, so much better than a real job !
In scenario 2 the share price continues to fall following the rapid perturbation that the short selling induced.
The share price could stay above S or it might even fall below it – it doesn’t really matter as Mr X is now not going to be using the warrants anyway. He simply allows the SP to bottom out and then buys the requisite number of shares back at a much lower average price (blue circles) than he got for the ones that were sold (red circle). Mr X has mugged shareholders who were unaware that he was playing games with the share price. Congratulations to Mr X – he is indeed Britain’s answer to Warren Buffett !
In this scenario Mr X would like the fraction f that he sells to be big – ideally 1 (100%). But no problem if it is not – he can simply repeat the process again and again until he runs out of shareholders to mug.
Scenario 3 – Share Price is undecided
A third option lies in between the first two described – what if the market does not recover or crash – what if it just stays static ? What can Mr X the habitual shorter do ?
In this case it would appear to make sense to Mr X to try and persist with the shorting strategy but in the knowledge that he now needs to be content with smaller returns than in scenario 2. Following the previous behaviour it looks like the market is pretty much asleep to the perturbations that the short sell has induced so it seems logical to assume that the SP will also remain fairly static following another sell.
Mr X then proceeds with a second aggressive sell, this time with the remaining fraction of shares, on the assumption that the SP can be driven even lower. He subsequently then closes on the full short of N shares with slow buying, knowing that the price he gets roughly matches the average of the second sell, but also knowing that he makes more of a margin on the shares in the first sell.
Congratulations once more – Mr X seems to have made money yet again without doing any work – he must be very clever. Where’s the problem ?
The answer to this question also explains why it does not make sense to do precisely what is described in scenario 3 from the word go. Or to put it another way – why should the shorter not just use f=1 from the start ?
Scenario 4 – Market (+Makers) see the short coming
Mr X may feel tempted to look at scenario 3 and say to himself – “gosh I cannot be bothered with that two stage process.- let’s just go all out with the full on short from the word go – for have they not heard that I am Britain’s Buffett ?”. The danger in this approached is shown in scenario 4, illustrated below.
This shows a strong market recovery in the case of going all in with a short on all N shares that Mr X has warrants for. In this case the direct market reaction to the short is perhaps a lot more than he had bargained for (it is evidently possible to overcook it!) or the Market Makers saw the short coming and rapidly dropped the Bid on the shares that were being sold.
By going with f=1 from the start – Mr X is basically saying that he doesn’t wish to ever contemplate using the play that was used in scenario 1 to counter a strong market response. He is ignoring the potential benefit of being able to adapt his behaviour to the actual market response. This decision can be really disastrous if the average price that he gets for the shares that he sold actually turns out to be less than the strike price of the share warrants – then Mr X would take a real cash loss when it comes to exercising the warrants that he needs to close the short. Using f=1 is not a smart strategy as it leaves no room for manoeuvre – it is not a hedged strategy.
Instead using f=0.5 (50% of the warrants in the first sell), the shorter can first probe the market and then adapt their response based upon what the market does. The presence of the warrants gives the shorter multiple options that now allows them to operate a hedged strategy. This is sometimes described as a Delta Hedge. Sounds genius right ? Where’s the catch ?
Scenario 5 – Just take the warrants
Scenarios 1-3 all seem to make a profit – only 4 seems to make a loss. In fact now that I have explained why you should not use f=1, but instead use f=0.5 that gives 3 out of 3 wins surely ? Well no – you need to compare with just taking the warrants as shown below.
So how do the different scenarios described above stack up against this very straightforward one ?
For a single cycle it is likely that every shorting strategy returns less profit than simply taking the warrants and cashing the shares in.
|Profit compared with taking all N warrants||Repeatability|
|Scenario 1 – Short f=0.5 and SP recovers||Definitely LESS||No|
|Scenario 2 – Short f=0.5 and SP crashes||Probably LESS||Might be able to repeat|
|Scenario 3 – Short f=0.5 x2 and SP static||Probably significantly LESS||Might be able to repeat|
|Scenario 4 – Short f=1 and SP recovers||Definitely LESS||No and perhaps also CASH LOSS|
Scenarios 2 and 3 only have the potential to return more profit if the shorter is able to repeat them over and over.
Mr X can only win as a shorter if he is confident that he can continue to repeat the shorting strategy by tricking shareholders into parting with their shares for less than they were worth only a few days before. Quite clearly this not possible in a market that understands what is going on and which exhibits strong recovery after each shorting attempt.
What can shareholders do ?
- Understand the strategies that shorters such as Mr X will attempt to use – both in pure trading terms, and in market commentary or bulletin board behaviour.
- Don’t set up Stop-Loss instructions – the brokers can see these and may encourage shorters to take advantage of you. They will claim that this is to encourage market liquidity, but what they really mean is increasing trading churn, and by no accident of history their trading commissions.
- Only invest in companies that you have done enough research to have long term confidence in. Would you put your cash into the Bank of D. Trotter and Son and still expect it to be there when you get back ? The same is true of shares – as the real Warren Buffett says “if you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes.”
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