What you need to understand about the stock market and BlackBerry shorts

CrackBerry's in-house analyst Chris Umiastowski talks about BlackBerry shorts

BBRY
By Chris Umiastowski on 6 Mar 2013 05:46 pm EST
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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. 

Topics: BBRY Editorial

Reader comments

What you need to understand about the stock market and BlackBerry shorts

49 Comments

Chris...well said...and we don't even want to think about the "naked" levels out there...news like the Germany deal has got to be causing some stress...

One thing I didn't notice mentioned and is a "great motivator" in a negative sense is that those who "long" risk loosing up to 100% of their investment. Since those who "short" have to effectively buy (later) what they sold earlier there is no limit to how much they can loose.

For example, if you "long" just one share for $10, your share may become worthless - you lost $10. But, if you sell someone the same share for $10 before you buy it for $30 later on, you lose $20. If the price goes to $100, you lose $90 - all that without mentioning any other fees.

That "sky is the limit" loss risk is a great motivator for doing something about it. Also note that "negative" marketing takes many shapes including being positive about something else that you may be "long" on.

I got 'into' individual stocks specifically to buy BBRY (RIMM) because I had followed BB10 development. I knew a few things....#1) BB10 was going to be awesome, #2) the stock was so very low because of how bad things had gotten, #3) there was a huge BB starved market. I did not know about shorting and about the rampant misinformation and outright lies that shorting would perpetuate. It is/was stunning in it's scope. I think this was a special case because a full 30%+ is shorted. That's BILLIONS of dollars. Also, some of the investors are fanboys of specific phones. Interacting with them was a very strange experience. Even in the light of evidence to the contrary, they stick to their positions. I'm trying to think up a way to take advantage of fanboys that also invest...they don't think straight...at all. I have made a lot on the stock already, but I'm looooong. This OS is amazing, it will find its market.

Ditto for me. I'd been following BBRY for a while and when I saw the price down around $7, I said 'enough is enough, I've got to buy some just to see what happens'. Next thing I know it was over $11 before I got some. Following this stock and all the 'shenanigans' has actually been very entertaining... like a sporting event. I have no doubt they'll do well.

Note also a couple of other things:

1) Because of the theoretically unlimited losses associated with short selling, professional short sellers tend to be more rigorous in their analysis. Which means that sometimes they're just plain right in believing a company is headed for a lower valuation - no sinister motives required.

2) Short shares must eventually be covered, unless the company goes bankrupt. So short sellers can put a floor under a stock's price once the stock has been sold down below a "fair" valuation.

And @winter_hat: for anyone trading with their own real money, love for a product is a liability in terms of your investment results. Markets will reward or punish BBRY based on financial results and forward guidance.

Full disclosure - I have traded BBRY from the long side during the recent rally, but have had no position for many weeks. And, I'm not a fanboy of anything. ;)

I didn't have love for any product myself. Well, I do, but I would never invest based on my personal preferences. I did naively assume that a good product would be reported as such. So, while the stock market manipulation tactics (fraudulent reporting on sales, stock valuation, etc) are meaningless to the general phone buying public, they do read reviews. Shorting (and competition itself) made for rampant biased reviews as well. Fun stuff. Educational.

A huge part of the reason I participated in part of the BBRY rally of a couple months ago was because of the extremely lazy and inaccurate BBRY bashing stories I was seeing all over the media, that were easily seen as being way off base by anyone following BB10 development. Where we go from here is a story yet to be told.

My MBA finance professor couldn't answer this question so maybe you can Chris. Why isn't short selling illegal? What benefit does short selling provide to the US market and economy? I just don't see it. If you don't like a stock just don't buy it. Betting against something, wanting something to fail, being negative, all of it just seems too sinister to me. I know it exists so people make money on the down side, as if they aren't making enough money already. Greed is the real reason short selling exists.

Some countries have banned short selling and the US should too. Without short selling there would be less of these stupid games. Maybe then stock prices and fluctuations would reflect true fundamentals like the company's performance and financial state. Sure people can still fabricate positive stories but they seem more difficult to pull off in my opinion. Especially with the internet, the playground of trolls, negative stories take a life of their own and spread like wildfire.

No, no, no. Legal short selling is a healthy part of the market ecosystem. Naked short selling (selling shares without first properly securing a borrow of the shares, or even selling shares that don't exist) is of course illegal because it is harmful to markets. Legal short selling is a perfectly reasonable practice to counterbalance irrational exuberance on the long side. Outright banning short sales is naive and does not work. Short sellers serve a purpose in the ecosystem by calling attention to, and acting on, valuations that have detached from reality on the upside. And as mentioned before, they also act as a shock absorber on the downside, when valuations sell far down below fair levels.

In theory you may be right. But short selling is limited to only hedge funds, and people with tons of capital. Furthermore, the incentive to lie and cheat is just too high. Unless you want to spend tons of money on cracking down on this stuff, in the end the costs outweigh the benefits. If valuations have been detached from reality then the financial intermediaries should be reporting on this, driving people to sell their stocks or people away from buying the stock. The reduced demand should lower the stock price.

Are you really implying without short selling we would have huge or more frequent bubbles (not like we don't already) because stock prices would always trade above their true value? I just don't buy it. Like most of these crazy derivatives invented by Wall St. it serves NO purpose to the overall economy. It is just another toy for these Adult kids to play with.

The potential upside of a long position is theoretically infinity, and the potential upside of a short position is only 100%, if the company goes bankrupt. Seems to me there is more pure financial incentive to lie and cheat about long positions than short positions. There were plenty of people who lost their money in the Y2K tech bubble and crash, who were hyped into buying fluff companies based on nonsensical valuation metrics like number of eyeballs on the website, etc.

Short selling is not limited to hedge funds. All you have to do is demonstrate you have enough risk capital for a margin account, tick off all the boxes to say you know what you're doing, and you too can be an "evil" short seller.

And yes, everything else being equal, we probably would have more bubbles without short selling. It helps to keep a lid on looney tunes asset valuations.

Right, theoretically the upside of a long position is infinity, key word is theoretically. Realistically though the probability of a company going bankrupt is astronomically higher than it going to infinity right? ;) Furthermore, I would posit it is much easier to manipulate the market to cause a company to go bankrupt than to cause a company to be insanely profitable. Remember, Fear is the ultimate emotion for controlling masses.

I agree on the Y2K issue, that is a bubble caused by speculation by the way. However, short sellers have their own blame for causing crashes, like 1929.

I disagree with your opinion and reasoning but it has been an interesting discussion for sure. My one takeaway is well designed incentives are essential. The "free market", which is an illusion, does a terrible job at this, which is why strong and effective regulations are needed now more than ever.

Ok, well "infinity" is an easy number to beat up on because it's purely theoretical. Replace it with some number that's a lot bigger than 100% but quite plausible and do-able - say 200%, and the argument stands.

Wall Street is predatory for sure, and companies that get themselves into a vulnerable position by e.g. issuing debt with dangerous covenants based on share price can and do get targeted by predatory hedge funds. But if management puts shareholders into harm's way with risky financing, there is some blame to be shared there if the shares decline. Those "evil" predatory hedge funds might make for a convenient villain to blame, but they may be only serving to accelerate the inevitable.

Regulations are important - very important. Without them, economies arguably underperform due to friction costs from a general lack of trust. But they can only provide so much protection without becoming stifling. It's a balancing act.

I agree with AjaxMilanBarcaSC - I see little benefit in short selling.

TBH, financial and commodities speculation in general seem to be a pointless way to suck money out of the economy without any real goods or benefit produced.

Speculators serve a purpose in the market ecosystem by providing short term liquidity. They tend to get demonized the most when a market move occurs that harms the broad passive investing public. We can of course have big problems when speculation gets to be such a large part of the market that it effectively becomes the market (as it arguably did in the US housing bubble of circa 2004-2007) but completely eliminating speculation is counterproductive. If there were not market participants willing to transact on short timeframes, you would pay higher spreads on your investment transactions.

A particularly fashionable demonization of commodity speculators happens when oil prices spike. But I never see anyone demonize speculators when oil prices plunge. In both cases, if speculators are truly responsible for the price sharply detaching from the fundamentals, the broader public should object, but they don't. Why? Perhaps because they feel the pain most immediately at the gas pump on a price spike, but if oil E&P companies have to shut production or delay investment because of sharp price collapses, something which will cause supply problems down the line, that is less of an immediate stimulus for the public to respond to.

Thanks for the write-up Chris! It still went way over my head :P I'm going to have to learn all this one day

Great article much needed to clear some of the misinformation out there or atleast provide a discussion on the stock

Thank you for the explanation - your short on short was short. Since I have done ZERO trading
in 1/2 a Century, I need a wee bit more information to make this "stick". Slightly longer sentences
with a bit more verbs, co-ordinate conjunctions, adverbs, etc. would likely clear up the diffuse
jargon. When I read it, it seems it makes its point about it, without its overly verbose investment in
its word use- itself, it's fine, though it lends itself in its own way, it seems, within it, to slightly confuse
newbies like myself, with its brevity. Good article. ( #5, need more input ) Thanks

Great story once again Mr. Umi!
Still not sure if I myself should ever go into the stock market but sure as hell learn more about finance and trading every time you post something. One of the few sites that have people on their team to cover multiple bases, not just some half baked product review site. I really do take interest in what people have to say, but going to a real financial trading site is just to overwhelming for me.
I like the pace at which I get insight in the world behind the stock numbers by reading your articles!

First, new site looks great.
Great article, a perfect example of this is going on right now on Blackberry facebook fan page. A person with the username Dividend Growth is going around spreading lies about a number of things related to the Z10. It is very obvious what he is doing. wish someone who could would shut this guy up.

Chris,
I wonder how much the decline in market cap. obfuscates the short interest percentage. As an example, lets assume you have a $1Bn hedge fund and you want to take a 3% long weight in Apple or Netflix or whatever long position you choose in tech. To hedge this, you need an offsetting short and given blackberry's struggles, this has been a popular choice. To offset your $30mm long position, you choose to short $30mm of blackberry. Now, at $13/share, you need to short approx. 2.3mm shares. When the stock was $50, you only needed to short 600k shares. Given blackberry's share price decline and its popular choice as a short hedge, the short interest gets to abnormally high levels. Despite the fact that retail investors believe that shorts are out to destroy BBRY, I believe the reality is that most of the shorting is just to hedge long positions, and given the decline in share price, many more shares are required to offset your long weights, thus making the short interest abnormally high. Obviously, if BBRY manages to stablilize and return to profitability, this will add to the upside given the need to cover, and find alternative short hedges in the tech space. thoughts?

An earlier poster asserted "professional short sellers tend to be more rigorous in their analysis", which I am inclined to believe is true, but I also believe that there are other short sellers who may not be as rigorous and instead look for an obvious hedge in the same industry to offset their long position just as you described with Apple/BlackBerry.

Something that goes without saying - but with implications that are often overlooked - is that for every single share sold there is a share bought. So when there is a situation where, say, 30% of the shares have been borrowed to sell short there HAS to be 130% shares bought and held long. The increased supply of shares offered to the market by short sellers must be absorbed somehow. Economics 101 will tell you that an ever-increasing supply will require ever-lower prices to clear the market. But that does not mean the additional 30% of "longs" are any less rigorous in their analysis. For a company like BlackBerry - that has hardly been a crowd favorite as a company or stock - I would suspect the people stepping up to buy the extra supply of shares have put plenty of thought into what they are doing.

If the supply of BlackBerry shares is being generated, as you suggest, by those simply looking to increase or hedge their exposure to Apple (which was the largest company in the world by market cap) it would follow that the shares of BlackBerry may be pressured overwhelmingly by something other than a diligent study of BlackBerry's fundamentals and prospects. And for an unloved company such as BlackBerry it would also follow that those buying the excess shares would have reason to be more rigorous than normal.

I would think that a lot of rigorous "longs" with longer time horizons would be in a better position than the "shorts" who expect to buy back shares from said "longs" in the near future. One way around that for the shorts would be to keep increasing supply (i.e. keep on shorting - which we have seen) until the company goes bust (which it now looks like we will not see.)

I will leave it to Chris to describe how BlackBerry's dividends and share repurchase policy (along with the prospects for BlackBerry being the target of an acquisition) play into the hands of short sellers but in a nutshell the shorts aren't sweating any of those things right now.

God no wonder we are screwed, I believe what you are talking about should be called Casino capitalism, whatever happened to integrity?
I guess that in the US casino's are only allowed on native american soil, water and Wall Street.

You know you know nothing about investing when a simplified explanation like this is still baffling. However, judging from the 'great explanation' comments I'm going to guess this was exactly that! :-)

In theory short sellers are sort of like bounty hunters: they deal with issues in the system that neither the police nor the other authorities have the time or the wherewithal to deal with (a good thing). However, in an imperfect system, some of them use techniques that fall outside the law (a bad thing). The system needs to be tightened up...

Wow, that video is pretty neat. I assume everyone else on here has seen it many times. But I haven't before today.
If you are a little guy and you are playing in the market with positions that you change much more often than twice a year, then you are going to get manipulated and abused. And really your time horizon for any stock play should be five years or more. But if you are buying and selling your long positions with only a few trades a year, then you are much less likely to be influenced by these games. The moves that Cramer talks about can only impact the stocks until the real facts come out. And we have reputable quarterly reports that reset things four times a year.

I'm long blackberry. But this is because I believe the OS is solid from a programming basis. And I believe the market it is selling into is gigantic and profitable that there is room for multiple players.

Don't know too much about stocks but shouldn't blackberry start buying more of their shares back starting right away to lessen the impact of hedge funds and any market manipulation?

Posted via CB10

This is a great Marketing opportunity. Their next promotional item should be a pair of BlackBerry Shorts. Would go great with a Splat t-shirt...

Chris, Your insightful analysis and professional comments have been a blessing for so many of us who have in interest in Blackberry. Our sincere Thanks and Gratitude. I look forward to following you on the new crackberry site.

Very informative and unbiased article Chris. This roller-coaster behavior of BlackBerry stock is going be prevalent for a while until the company fully stabilizes. Stock buy-back as someone suggested below is one effective way of stabilizing the stock, but you and I know that's not going to happen simply because it costs a lot to make that happen. And we cannot deny the fact that BlackBerry needs to use its cash where it really matters right now - which is "Staying Alive" to be able to fight another day. I commend Thorsten Heins and the Board for an excellent execution in the last couple of months; and it's looking more and more apparent that BlackBerry is not going away anytime soon as most had feared / wanted, depending on which circle you talk to.

This is one of the most misinformed, misleading article ever. Since 2008 everyone wants to blame hedge funds and "manipulation" of the market. Crackberry please stick to your "tech" articles as that is where you specialize, or get a serious finance/analyst to do these articles if you so desire. A witch hunt against hedge funds helps no one.

"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!“

Hm it happened to Nokia the last summer thanks to traders of Morgan Stanley and Goldman Sachs and it's not an "exceptionnal case" when you talk to some analysts...

Chris, as you commented in a past article. The 1.6% market share number blasted around in the media was promoted , yes promoted as BBRY total market share of the global smartphone market. If you asked anybody about this 1.6% number, it stuck in their minds as BBRY market share of the smart phone market. What it actually reflected as you commented was the 1.6% market share number reflected the BBRY smartphones sold, not the user base number which is much higher. BBRY does have about 80M users.

LOVE the new site + excellent article. I like coming to sites like this and learning something new I didn't expect!

Hello Chris,

I have a degree in economics but I feel totally stupid because I just cannot understand the fundamental of finance. How can you 'borrow' stocks or sell stocks that you don't own? I just don't understand finance on a very fundamental level. This is frustrating as it presents itself as a limit to my intelligence, yet the financial world is incredibly powerful and dominates the 'real economy' (which, by the way, is something that I am able to understand). To ignorant people like me, the financial markets come across as scandalously fraudulent and dominated by people who appear to be highly-intelligent thieves.

(Also a BlackBerry owner :) )

Thank you for providing this article. Also for a short squeeze to happen shouldn't there be a large ratio of naked shorts? In covered contracts the shares are already owned.