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What is Short Selling and Why Have Short Sellers Disliked Facebook?

Facebook Hasn’t Been Kind to Short Sellers so Far as Sustained Share Price Losses Make the Practise too Risky

by Anton Aleksandrov

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Facebook’s IPO

Facebook’s (FB) IPO generated a lot of buzz amongst investors. It was the most exciting IPO in years and naturally the expectations were sky high. However, the first couple of weeks were quite rough for the social media giant, which saw its share price dropping significantly. This development was a major upset, but it also might hold a silver lining for the Palo Alto-based company. It has limited short selling to much lower levels compared to similar internet companies, which went public in recent years.

What is Short Selling?

Short sellers borrow stock from its owner, sell it on the assumption that the price will decline and they will be able to buy the stock back cheaper, profiting from the difference. The nature of the operation suggests that short selling is most effective when the stock is overvalued. Although it has long been a practice of seasoned stock market players, short selling has received a lot of bad press of late. This is mainly due to accusations of coordinated mass short-selling by traders and firms specialised in the practice destroying share prices of some high profile companies such as the case of HBOS. Individual traders can short sell, but the practice is mainly associated with hedge funds doing it on a large scale. The company’s slump in share price was a major factor in its subsequent acquisition by Lloyds TSB. Because some companies are known specialists in short selling, investors who see that they are selling off shares in a particular company may also be strongly induced to sell in the belief that share prices are set to plummet, setting off a domino effect.

Not all analysts agree that short selling was the only, or even primary, reason for HBOS’s disastrous share slide and many practitioners of the short sell use the defense that they are merely highlighting to the market that the shares were overpriced in the first place. Nonetheless, in the UK regulations were introduced in 2009 preventing short selling of 29 key financial shares in an effort to prevent what is considered a sometimes coordinated attack on share price which could result in the dangerously consequential collapse of critical financial institutions if not controlled.

Short Selling of Facebook Too Risky

In the case of Facebook, the negative movement of stock price after its debut on the market and the company’s rich valuation initially spurred short sellers to take action, sensing the opportunity to make profit, but with the price falling even further,short selling became less attractive. It was just too risky. “The risk/reward doesn't make sense to me right now,” said Steve Spencer, who co-heads a proprietary trading shop in New York. He began shorting Facebook at $32, the Tuesday after Facebook’s IPO, but now believes that there is no point continuing the practise. “If people wanted to make a bet on the short side, they were doing it in the mid-30s” he added.

According to Jay Ritter, a University of Florida IPO expert, when price drops it is “time to take profits” because it becomes less likely that a further decline will follow. His and Mr. Spencer’s words are generally supported by traders’ behaviour since FB’s IPO.

Of all 421 million shares in the initial public offering about 8.4 percent were sold short as of May 31. This percentage is lower than that of half of the internet-based companies that went public in the past year, including LinekedIn Corp, Pandora Media Inc Angie's List Inc and Groupon Inc. And in 2004 Google Inc also attracted much higher short interest after its initial public offering.

Does Short Selling Indicate a Company is Likely to Fail?

Short interest doesn’t give a clear indication about what the performance of a particular company might be in the future. “Outside of IPOs, almost all of the research indicates that short selling is a negative signal,” says Ben Blau, a finance professor at Utah State University.

But IPOs are different and tricky to call. Some companies which have attracted high (higher than Facebook) short interest at their IPOs have subsequently done quite well for themselves like Google and Ebay Inc. Others have failed miserably.

Hope for Facebook

Many small investors are still hopeful that the social media giant will bounce back. Tony Allen a Detroit real estate entrepreneur who bought 50 shares at $42 on the day of the IPO admitted that he had never imagined that the performance would be that bad. Yet he still hopes for a turnaround and is keeping his shares. And Facebook might not disappoint this time. Since the shaky start Facebook shares have recovered and are now traded at levels around $32 per share. So, this may not be the best time to go bearish, especially with Facebook’s new ad strategy, which is expected to give another boost to the company’s stock.

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