Imagine if you knew the 2007 financial crisis would happen and everyone else was none the wiser? How could you have profited from it? Simple, short the market! This was the plot of the widely acclaimed book, The Big Short: Inside the Doomsday Machine, which was later adapted into the Academy Award winning movie, The Big Short.
What is Short Selling?
While the average investor buys a stock expecting the price to rise, "short" bets on the stock do the opposite by betting that the price of a stock will fall. Short selling, otherwise known as reverse stock buying, is an investment strategy where an investor borrows a security, sells it at the current market price in anticipation that the price will fall in the near future, repurchases the security at the lower price, and then returns it to the original owner. The profit made is the difference between the price he initially sold the borrowed security at and the price he repurchased it. If this gap is negative i.e. the security increases in price, the investor is obliged to buy it at the increased price and records a loss on the investment.
As you may be able to tell already, an essential part of executing a short is borrowing the securities you need from a willing counterparty, otherwise known as securities lending. The owner of the security (e.g. a Pension Fund Administrator) lends the financial instrument to an investor, who pays the pension fund interest or an agreed fee over the period the borrower holds the security.
Make any sense yet? It usually doesn't the first time round. Shorts are not exactly straight forward. Perhaps this explains why they are often used for questionable trades and remain popular among the speculators.
Let's use a hypothetical illustration. In July 2014, I could have made a play to short First Bank Nigeria Holdings PLC (FBNH). The company's dwindling asset quality – captured by their non-performing loan ratio – was bound to hit the share price within a year. All I had to do was borrow and sell 1,000,000 units of the shares at around ₦14.85 each. Within a year, the share price had fallen as expected and I would have closed the short position, bought back the shares at about ₦6.36 each, and netted a nice profit.
If you're wondering how much I would have made, the borrowed shares would have sold for ₦14,850,000, and I would have repurchased them for a comparatively paltry sum of ₦6,360,000. My nominal profit? ₦8,490,000.
Short selling on the NSE
The Nigerian Stock Exchange (NSE) introduced short selling and securities lending in 2012. In the first phase, short selling on the NSE was only open to approved market makers; these are registered dealers in securities who promise to buy or sell at specified prices at all times. A market maker quotes both a buy and a sell price of a financial instrument and profits from the difference (termed the spread) between both prices. However, to increase liquidity in the market, everyone's now allowed to short; however, this is only after making the necessary arrangements with a registered securities lender.
To execute a short, the NSE requires you to be covered through an approved dealing member. Essentially, you have to buy back the exact amount of shares or security you borrowed from the market before you are allowed to close your short position. So if I had shorted FBNH, before closing the position, I would have to buy at least 1,000,000 units of the stock before I could close my position. The alternative would have been to execute a naked short, which is illegal, by shorting the stock without borrowing it from anyone – essentially betting on shares that don't exist. Due to various loopholes in the rules, and discrepancies between paper and electronic trading systems, naked shorting is still possible.
When is Nigeria's Big Short?
Despite the NSE’s best attempts, short selling is yet to fully take off on the exchange, for a number of reasons. Firstly, executing a successful short sale on the exchange is hindered by a raft of bureaucratic processes created by the exchange itself. These bureaucratic processes, notionally in place to manage risk, discourage interested traders (or speculators). Also, the parties most likely to lend securities for shorts, i.e. long-term investors, are put off by the risk of not recovering/receiving the security back from the borrower (default risk).
Even with the regulatory and administrative frameworks already in place, the deal isn't sweet enough for potential short sellers in Nigeria to take the plunge. The strategy is unappealingly risky for the typical Nigerian trader as while it can be profitable, its underlying success is contingent upon a decline in the market – or at least a stock, contrary to the long-term upward trend in equity markets.
So what is the incentive to bet against the market trend? The temptation to short comes when you have good reason to believe that a company's share price will trend downwards, perhaps if you judge the stock to be overvalued or you are wary of a bubble. The 2007 financial crisis offers one such example, and if you were in the market during the crisis, shorting would have been the most effective, and perhaps, the only way to make money.
The point is, under the right circumstances, short selling can be a quite profitable investment strategy but usually for experienced traders and investors who understand (or at least pretend to) the risks and can tolerate it. For the average Musa, like you and me, it's probably best to stick to the good-old fashioned buying and selling of securities. Why complicate things that are already so difficult?