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SHE SHORT-SELLS SHOES ON A SHORT-SALES SHOE SITE

OR, HOW VOLKSWAGEN BANKRUPTED THE HEDGE FUNDS

A lot of people seem to struggle to understand how people make money in the stock market by ‘betting on shares to go down’. Actually, you can do this yourself, and you don’t even have to have a brokerage account to do it. All you need is eBay, and an opinion on the likely future direction of the price of something. Say, you’ve just developed an opinion (shared by at least one of the authors) that Jimmy Choo women’s shoes are wildly overpriced…

’SCUSE, CAN I ‘BORROW’ YOUR SHOES?

Step one, you ‘borrow’ a pair of these overpriced shoes from your sister/best friend/more highly paid colleague. Then sell them on eBay for the current average price, and pocket the cash. Put it safely away, i.e. in a shoebox. When the irate female you borrowed them from starts asking for her Jimmy Choos back, go out and buy a pair at your local second-hand designer shoe shop, using the cash that you’ve kept in your special shoebox shoe trading account. If your prediction is right, and the price has gone down, then you will have some money left over in the shoebox, after ‘closing out’ the transaction, and this is your profit.

BACK OF THE SHOEBOX

On the other hand, maybe you don’t want to close out your trade just because a certain femme fatale wants her shoes back – perhaps the price hasn’t moved in your direction as far or as fast as you wanted it to (or indeed at all). In this case, you can keep the trade open by finding another long-suffering woman with a pair of Jimmy Choo shoes that she doesn’t want to wear that evening, and deliver those to your first victim instead, keeping yourself in the position of having one pair of borrowed shoes (and thus an obligation to return a pair of Jimmy Choo shoes at some date in the future – this is your ‘short position’), and one sum of eBay sale proceeds in cash in your shoebox.

SHORT POSITION

Effectively, ‘betting’ that the price of a share will go down. The way this is achieved is to borrow the share and sell it, in the hope that, when you have to return the share, you will be able to buy it back in the market for a lower price.

Sharper readers will be objecting at this point that this sounds pretty unrealistic. (Not the bit where there are loads of women with vast collections of unworn shoes in their cupboards, that’s spot on.) But the bit where you can find exactly the specification of shoes that you borrowed in order to return a pair to the first shoe-deprived lady that she will recognise as equivalent to the ones that you borrowed.

HOW DARE YOU SAY MY SHOES ARE FUNGIBLE?

This is a real problem with the analogy – although all equity shares in any given business are pretty much identical, shoes aren’t. If I have a share in BT or IBM, it’s exactly the same in form and function as a share you own in the same company. This is why loads of people short-sell shares, but many fewer try to short-sell shoes. What we are talking about here is called ‘fungibility’ – the property of being able to deliver one asset in place of another. In general, all of a company’s shares will be fungible for each other in exactly the way that shoes aren’t. There is no reason whatsoever that someone would be able to tell the difference between two different shares, as the only difference that exists is the serial number and the record of who owns it. Of course, some people would argue the same is true with shoes, but they are ignorant and wrong. (Readers may sense that the authors are not speaking wholly with one voice in this chapter.)

FUNGIBILITY

A piece of financial jargon effectively meaning that two bits of paper are interchangeable. Pound notes are fungible – it doesn’t matter which particular one you have. So are most shares. Bonds, however, are not necessarily fungible – different bonds have different maturities and interest payments. In the world of physical objects, hammers and shovels are pretty fungible – wedding rings, decidedly less so.

BONDAGE

However, the situation with bonds is different. If a company has bonds outstanding, then you can’t rely on the bonds to be sufficiently identical to be fungible. Typically, a company will have different bonds with different coupons and maturities, and you can’t deliver one of the ten-year bonds if you borrowed one of the five-year bonds. Since the bonds are issued in large unit sizes, and bonds are generally fungible within each issue (as long as the coupon and maturity are the same, by and large), this doesn’t mean that it’s impossible to short-sell bonds. But it is a lot more difficult, even if you have the assistance of a really good broker.

BONDS

A bond is a tradeable loan issued by a company or a government. Company bonds are a way of raising money for a company – rather than borrowing money from the bank, the company sells IOUs to the public.

SWAPPING CREDIT

That, in summary, is a large part of the reason why the credit default swap (CDS) was invented. It had always been irksome to that part of the bond market that spends its time analysing the creditworthiness of companies that there was no easy way to trade based on the predictions their analysis threw up. If you wanted to sell a company’s credit risk because you thought it was risky, you would have to short-sell a specific bond. And bonds are in general more difficult to borrow than shares; the owners have this irritating habit of wanting their bond back when they need to realise some coupon or principal income, leaving you scrambling around for a replacement. With the CDS, however, the trading is concentrated in one (imaginary) security and, because it’s a derivatives contract, there is no question of needing to borrow or deliver the underlying securities – you just make bets with other investors and settle up periodically based on the price where the bonds trade.

CREDIT DEFAULT SWAP

This is a derivatives contract that pays out a sum of money if a particular company defaults on its debt.

THE NAKED SHORT SALE

One more thing to let you know about – and we don’t advise doing this – but, if you’re feeling particularly lairy, then there is a way to sell shoes short with a bit less effort, but a lot more risk, and it is even almost legal in some but not all jurisdictions. Say, you want to short-sell the even more overpriced Christian Louboutins, but your sister only has Jimmy Choos (and the two aren’t fungible, believe me). You could copy a picture of some Louboutins off the web, and put up an auction on eBay with thirty days’ delivery, trusting in your own ability to scrounge some up from somewhere at a lower price within the next month.

Now this is very much against the terms and conditions of eBay and, if you are caught doing this sort of thing a lot, your account will probably be suspended. The reason is pretty clear of course – eBay know that auctions of this sort tend to result in failed deliveries and unsatisfied customers pretty frequently, and they also know that this kind of failure tends to reflect on people’s perceptions of eBay as a whole.

When traders do the equivalent thing on a stock market – selling a stock short without first finding the borrow – it’s called a ‘naked short sale’. This is almost as exciting as it sounds, and so it’s illegal in a lot of markets.

AND HOW VOLKSWAGEN BECAME THE MOST VALUABLE CAR COMPANY ON EARTH, VERY BRIEFLY

Even when it’s not illegal, it’s really very risky. The danger with naked short-selling is that, without the constraint of needing to borrow shares before shorting them, it is possible for there to be more short positions than there are shares available. When this happens, it’s not even mathematically possible for all the short-sellers to deliver all their shares and, in the resulting ‘squeeze’, some pretty alarming things can happen. This isn’t just a theoretical possibility: it happens in real life in markets where naked short sales aren’t banned. In 2007, a bunch of hedge funds badly underestimated the proportion of Volkswagen shares that were controlled by the Porsche corporate treasury. When they got the bad news and all scrambled to try to get hold of the small number of shares available, the price went up so far that Volkswagen briefly became the most valuable car company in the world, by market capitalisation.

A few hedge funds disappeared forever due to the losses on that one, because, while the most you can lose by buying a share is all your money, the losses on a short sale are theoretically unlimited.

As the proverb goes:

‘He who sells what isn’t his’n

Must buy it back, or go to prison.’

Or as another proverb goes:

‘Get away from my shoes!’