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The Big Short: What is Short Selling Anyway?

The recent release of the movie-version of the best-selling book, The Big Short, reminds us of the risky bets that some investors take when they anticipate the stock market, a particular industry, or a certain stock will decline in value. In addition to the movie being wildly entertaining, it does an excellent of job explaining abstract securities concepts that lay people can understand. The movie does this through various celebrity cameos, like the snapshot above of model Margot Robbie, where the celebrity gives a brief lesson with examples on an otherwise complex securities concept. Hence, the movie gives us the perfect backdrop to explain the difficult concept of short selling.

Short selling is the sale of a security that is not owned by the seller or is borrowed in the short term from a third party. The motivation behind short selling is the investor is betting that the security’s price will decline in value and will be repurchased later at a lower price for a profit. Because the risk of loss by short selling is substantial, it is considered a high-risk investment strategy and is typically appropriate for only highly experienced investors.

The Big Short was a great example of short selling on a grand level, where several groups of investors were not just betting on a certain stock declining. They were betting on an entire industry – the housing industry – crashing.

In the real world, there are additional hazards of short selling of which investors should be aware. For example, many investors own “proprietary” mutual funds in their brokerage accounts. Proprietary funds are ones where you own, for example, a Morgan Stanley owned and managed mutual fund in your Morgan Stanley account.

A hazard for investors with proprietary funds is that sometimes the brokerage firm does not fully disclose to its fund investors when the brokerage firm is selling short on a particular stock in the firm’s other accounts. In other words, the firm may betting against the stock increasing in value in its own accounts, but doing the opposite in its proprietary mutual funds that the investor owns.

In one recent example, FINRA sanctioned Morgan Stanley $2 million for violating the SEC’s short-selling rule, which requires brokerage firms to give an accurate tally on its short positions in a particular stock. See FINRA News Release. Per the news release, Morgan Stanley violated this rule over a 7 year period.

The bottom line is that short selling is an investment strategy only to be considered by experienced investors. Nonetheless, it is a concept that investors should understand in general, especially when it comes to proprietary funds where a firm may be selling short in one place and buying long in another.

If you know a financial advisor or brokerage firm that is recommending overly aggressive investment strategies, such as short selling, or making their own investments inconsistent with their proprietary funds’ strategies, contact McCabe Rabin, P.A. for a free consultation at 877-915-4040.

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