Here’s the set up.
You are a risk manager at a major hedge fund.
You are shorting a large portion of a publicly traded company.
They’ve found you!
Social media has identified your company as a culprit in shorting a beloved company.
The stock starts rising.
What do you do?!
Here’s what you do.
Buy calls that are out of the money but at a price that will be crossed.
If you want to buy the calls for free, raise some money by selling puts at the money.
Start buying back your shares.
Repeat the above steps until your short position is closed.
As you approach buying back all the shares, start buying back your puts.
That's it, you're out.
How to End Up with More Than 100% Short Positions
You think the stock of ABC Software Company is way overpriced.
The products aren’t selling.
The competition is far outperforming.
And, the CEO was arrested after having roamed the street at night claiming to be Batman.
So, you decide to help humanity, and yourself, by shorting the stock in order to make the market reflect the reality that the capital invested in ABC Co is better spent elsewhere.
You go to your brokerage, and say, I want to borrow shares in ABC company. Another customer at the brokerage has filled out some paperwork that allows their shares to be lent out.
You borrow some shares of ABC from that customer. You’ve got to give them back at some point. In the meanwhile, you sell those shares.
When you sell those shares, that puts downward pressure on the stock. It’s kind of self-fulfilling. But when you buy back, you’ll be driving it back up. So, there’s a cosmic fairness here.
Now you wait for the world to discover that the company is in trouble. When that happens, you will buy the stock at a cheaper price and return it. Everything will be right in the world.
But the stock doesn’t move.
And a few weeks later, there’s more news.
The CEO is at it again, and this time he was arrested after roaming the streets dressed as a vampire.
Why doesn’t the stock fall?! You don’t know; but you think it should.
Motivated by this, you short the stock again. You borrow the stock again. And you sell it.
This time something interesting happens that you’ll never know about. After you short sell your shares, there is a new owner of those shares. That owner then lends those shares to someone else who wants to short the company. By chance, these exact shares have been lent twice. And for each share that actually exists in someone’s possession, two are short. If this happens a lot, it turns out that more than 100% of the company has been shorted.
Coda 1: The Shorts
Now, something unexpected happens. The ABC Software Company that you have been shorting announces a story. It turns out that a movie studio has offered to pay them hundreds of millions of dollars to do the special effects for their upcoming movie and video game franchises called Batman and Morpheus the Vampire. The CEO is not so crazy! It was a gorilla marketing campaign. And the stock starts flying!
People race to their brokerages to buy shares. Your broker, Sherwood Forest Brokerage LLC, is having a major problem. They are worried that customers like you are going to be unable to afford to buy back shares you have shorted. That’s a problem because they need those shares in order to be able to sell shares to new customers.
Because they are afraid that you will not deliver the shares that you have sold short, they need to hold off on selling. And now, customers are furious because they can’t get in on this rising stock.
Coda 2: The Longs
Now something else unexpected happens... the stock price is soaring. And customers are trying to buy all they can. But, suddenly, the movie scripts for the Batman and Morpheus movies get leaked to the public. The stories are horrible. Posts on social media say the story is worse than The Last Jedi and Justice League combined. The stock falls to the ground and customers who have been purchasing on margin have now purchased shares at a very high price. They might not be able to pay. To protect itself from this type of loss, the brokerage increases the margin requirement. Some investors who like the Batman and Morpheus movie scripts are furious. They say that Sherwood Forest Brokerage is protecting the shorts.
The views expressed are those of the author and do not necessarily represent the views of any other person or entity.