I’ve been meaning to address this topic for a while now, and after getting a specific request from a reader last week I figure why not get it done.

Shorting BBRY stock is the topic in question.  I’ll start with a quick explanation of what shorting is and then explain how people can combine shorting with illegal stock market mechanics to make money.  Hopefully you’ll walk away with a better understanding of the whole topic.

First off, what exactly is shorting?  It’s the colloquial phrase for “short selling”.  Short selling means to sell stock that you don’t own.  Technically this means you are borrowing stock in order to sell it.  Being “short” means you owe shares back to whoever you borrowed them from.  If you borrow stock at one price and buy it back, later, at another price, your profit is the difference.  It’s the reverse of the normal buying today and selling sometime in the future. 

As an FYI, owning stock is called being long.  Selling stock you don’t own is called being short. Pretty simple, eh?

People short stocks for two reasons.  They either do it because they think the price will drop, or they do it to hedge (remove risk from) another investment.  For example, say we take a drive down memory lane to when BlackBerry stock (then RIM stock) was $40 per share.  Say you were an employee with options that would vest soon with an exercise price of $10.  You might want to lock in your profit by shorting the stock at $40 and being sure that you’d make a clear profit of $30 per share once your stock options vested.  This kind of thing happens all the time and it’s perfectly legal. 

Now let’s talk about hedge funds.  The term “hedge fund” is supposed to mean an investment firm who hedges positions by being long some investments and short others in order to hedge the downside risk of a collapsing market.  The reality, though, is that hedge funds these days are just labels for privately run money managers who can do whatever they like. They can short stock whereas most mutual funds and pension funds are not permitted to do so.  Their mandate doesn’t allow for it.

Say you run your own  hedge fund and you believe BlackBerry 10 is totally doomed.  The way to make money from this is to short the stock, just as someone with the opposite view would try to make money by going long.  It’s just a bet.  If you’re right, you make money.  If you’re wrong, you lose.

Shorting stock in this manner is perfectly legitimate.  And while I can’t prove it, I would say most stock that is shorted is shorted in legitimate ways. 

If people get really bearish on a stock, the number of shares short can climb quite high.

If people get really bearish on a stock, the number of shares short can climb quite high.   People often use the term “days short” to equate the number of shares sold short to the market’s average daily trading volume.  If the average trading volume is 10 million shares and there are 100 million shares sold short, then theoretically it would take 10 days for the shorts to “cover” their position(meaning to buy enough stock to close out their short position).  Keep in mind very few days are average days in the market, so it’s just a model and it is not reality.

But the point is ... the more shares sold short the more volatility there will be around events.  If there is a ton of stock sold short and good news comes out, the shorts scramble to cover so they don’t lose too much money.  Hedge funds tend to have very short term measurement periods.  Measuring monthly results (and getting a bonus dependent upon them) is fairly common in hedge fund land.  So analysts at hedge funds care a LOT about being right in the very short term.  This perpetuates volatility.

If there is a ton of stock sold short and good news comes out, the shorts scramble to cover so they don’t lose too much money.

And this leads us into the sinister stuff.  Shorting is perfectly legal.  But passing on rumors that you know to be false, based on an expectation that they’ll move the stock price, is completely illegal.  Unfortunately it’s also very hard to prosecute against, so it happens a lot.

If you were short BlackBerry and wanted to make sure there was negative news flow to hammer the stock down, you might find a way to manufacture negative news.  Outside of the investing scene, a fellow named Ryan Holiday wrote a book called “Trust Me I’m Lying:  Confessions of a Media Manipulator”.  In Holiday’s industry (not the stock market), there’s nothing illegal about this (at least I don’t think there is). 

But in the stock market you’ll find manipulators who execute the exact same strategies of planting false stories at small media outlets and growing them until the giant financial news sites are compelled to write about them because of the force of social proof.  If so many smaller outlets have written up the story it has to be true!  Not.  Anyway, if shorts do this to drive a stock price down, they are breaking the law.

Given the short term focus of hedge funds, this all makes sense, doesn’t it?  Planting negative news on a large public company is not so hard.  But making it stick over a long period of time IS hard to do. 

Since I’m writing about shorting, I think it only makes sense to also discuss how sell side analysts can get involved in this stuff.  As a reminder, the “sell side” are the investment banker shops.  JP Morgan, Goldman, RBC, etc.  Their equity research teams write reports on stocks, and those analysts are called sell side analysts.  Money management firms are called the buy side.  The buy side uses the sell side for research and to execute trades.  Long, short, sell side, buy side ... pretty easy so far right?

Among amateur investors (and observers who don’t know much), there tends to be this belief that analysts issue recommendations simply so their firm can profit by tricking the general public into taking on action while their trading desks do the exact opposite.  “Hey, BlackBerry is doomed!  Tell everyone it’s doing great while we dump our stock!“

Sorry ... no, it doesn’t work that way.

Sell side shops are not in the business of making investments in the stocks their analysts write research on.  They trade on behalf of their buy side clients.  They may go long or short at points in time only to help a client do a trade.  For example if a big client wants to sell a million shares and they can only find a buyer for 800,000 shares, they may take on the other 200,000 shares as what is called a “liability trade” (meaning the firm is taking liability for these shares).  They dump the shares as quickly as they can when this happens.  They don’t want the risk.  Most of the time the analyst publishing research wouldn’t even know about this liability position.  And even if the analyst were entirely unethical there wouldn’t be enough time to craft a fake story and publish a fake report.  In other words, all of this stuff is a bunch of crap that uneducated investors spew without a proper understanding of how the market works.

Finally, I think it makes sense to point out that making up fake bad news to go along with a short position is the same thing as making up fake good news to go along with a long position.  This stuff happens too.  It just isn’t talked about nearly as much.  And it’s just as illegal. 

So in closing, shorting is primarily used to bet against a stock.  It can be done totally legally and ethically.  In this industry I’ve made good cash shorting Nokia, for example ( I have no position in Nokia now).  But if people short stock and then manufacture fake bad news to hurt the share price, they’re breaking the law. Good luck catching them, though.  It’s tough.