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Shorting stocks - when swimming against the tide pays off

Shorting is one of the trading techniques that, by its very nature, is perceived as controversial by the public, however, its enormous profit potential is undebiable. Join us as we take a look at 3 of the most famous investors in history who singlehandedly made a fortune going against the market while shaking the world of finance to its core at the same time.

What is shorting

Shorting (or short selling) is a form of investment in which you speculate on the decline of a stock, currency pair, stock index or other trading instrument. By its nature, short selling is often carried out on financial derivatives, i.e. instruments whose value is only derived from the price of the underlying asset, so that you are not their rightful owner, but only speculate on their price. A suitable instrument for shorting may be, for example, CFD shares.
 
In the case of real shares, traders who short sell are borrowing them in the belief that their price will fall and they will then be able to sell them to buyers who will seek these shares precisely because of their lower price. This is a relatively risky way of investing because, theoretically, there is no limit on price growth of any instrument.
 
Shorting is used, for example, when hedging long positions (to mitigate losses if a trade does not go as planned) or when a trader is almost certain that the price will fall in a particular market and wants to make a profit. Historically, shorting of some investors has led some to often controversial conclusions, which is precisely the case with our trio.

 

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3 most famous examples of successful shorting in history

Now you know what shorting is and how to use it when speculating on falling share prices with CFD contracts. However, there is a big gap between theory and practice. So let's take a look at some of the most famous "shorts" that have made history. They might just inspire you to make similarly successful trades.


Jesse Livermore - the pioneer of day trading


One could write a very extensive article or even a book about Jesse Livermore's life (one such book, Reminiscences of a Stock Operator, has even been published). However, it is possible that you have never heard of this trader. Yet it is Jesse Livermore who is considered the pioneer of intraday trading. Since he was active mainly in the early 20th century, he is not well known among the current generation of traders. However, some of his speculations have gone down in history. His ability to predict stock market crashes even earned him the nickname "the bear of Wall Street".
 
His first known short came in 1906, when Livermore successively shorted over 20,000 shares of the Union Pacific railroad company. A few months earlier, he had been riding a bull run, and his instincts told him that the bubble was about to burst. Let us just recall that in the early 20th century it was very difficult to trade using the fundamental analysis because the information was scarce and often unavailable as large number of companies did not even publish their financial results. Moreover, manipulating the markets was much easier back then than it is today, and many traders took advantage of that fact. Livermore had no choice but to rely on his instincts.
 
So he looked for opportunities to speculate on the market downturn, and the choice fell on the Union Pacific railroads. He first shorted 5,000 shares, but then came the great tragedy that made Livermore rich. A major earthquake on the west coast of the USA destroyed almost 80% of San Francisco and killed over 3 000 people. Livermore felt that the newspapers were not reporting the true extent of the tragedy and gradually shorted 20,000 shares of Union Pacific. This bet paid off handsomely, and Livermore made over $250,000 on a single trade.

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Chart 1: The evolution of the Dow Jones index from 1929 to 1930. Source.

His biggest victory, however, came more than 20 years later. Livermore once again showed great instincts and gradually sold off all his long positions and in turn built a large short position in the stock markets before the Great Depression of 1929. On Black Friday, October 29, 1929, Livermore reportedly made as much as $100 million in the historic stock market crash. This drew the ire of many Americans, who lost virtually everything in the Depression, to Livermore. His story does not have a happy ending though as he gradually lost his fortune and depression drove him to suicide in 1940.


David Einhor - the man who predicted the collapse of Lehman Brothers


Fast forward almost 80 years into the future, markets are no longer overseen by the SEC and manipulated as easily as they were in the early 20th century. Yet, relatively often, a great opportunity to speculate on falling stock prices appears.
 
David Einhorn was already a well-known trader before the 2008 mortgage crisis. In 1996, he founded the hedge fund GreenLight Capital, which focused on long/short positions. However, he is most famous for his short position on Lehman Brothers stock, which his fund entered in July 2007 - more than a year before the bank's actual collapse.
 
What led David Einhorn to make such a risky bet? Einhorn believed that Lehman Brothers had high exposure to illiquid mortgage investments and that these investments were not properly recorded on the bank's books. Einhorn even went public and called Lehman Brothers' accounting methods questionable. The genius of this move began to show in March 2008, when investment bank Bear Stearns was bailed out by the US Federal Reserve. Lehman Brothers was considered to be even more at risk than Bear Stearns, as confirmed by the bank's subsequent financial results, which showed a loss of USD 2.8 billion for the quarter. Within a couple of months, Lehman Brothers went completely bankrupt. David Einhorn then made hundreds of millions of dollars on his shorts.


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Chart 2: Evolution of Lehman Brothers shares since 2006. Source.

But David Einhorn wasn't the only one who made a fortune from the mortgage crisis. Each of you has probably seen the movie The Big Short or maybe even read the book by the same title. The main characters are a group of traders who predicted the bursting of the mortgage market bubble. To speculate on the market decline, however, they did not short stocks themselves, but CDOs (collateralized debt obligations). The founders of Cornwall Capital, Charlie Ledley and Jamie Mai, were already quite successful "shorters" before the mortgage crisis itself. Their analysis and instinct told them that the mortgage bubble was about to burst, so they decided to short CDOs by buying credit default swaps. Both made over $80 million on their speculation.

Even more successful was Michael Burry, who is the founder of Scion Capital and one of the main characters in The Big Short. Burry was probably the first investor to realise that the US was facing an economic crisis caused by mortgage defaults. So Burry got the big banks to sell him credit swaps on the mortgages he thought were most vulnerable. The bet eventually paid off and Burry made a profit of over $700 million for his fund.
 

Fahmi Quadir - David vs Goliath


Shorting is not only the domain of men, that’s why we have to include Fahmi Quadir's feat among one of the best shorts of recent years. It doesn't have to be the most profitable short, often it's just the fact that the trader used analysis and his own instincts to uncover something that probably only the executives of the shorted company suspected. This is where Fahmi Quadir excelled. Quadir is the founder of Safkhet Capital, a fund that focuses exclusively on short positions. Her famous short came in 2015, when she built a speculation on the falling share price of Valeant Pharmaceuticals International. Valeant was by then the darling of Wall Street, and the company's stock rose steeply. However, the company didn't have many products of its own and went in the direction of acquiring other pharmaceutical companies that already had certified drugs in production. With acquisition, Valeant made the drugs significantly more expensive, increasing its price sometimes by hundreds of percent.

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Chart 3: Valeant Pharmaceuticals stock development. Source: fool.com

In addition, information gradually began to surface that Valeant was artificially inflating sales of its drugs. The unethical drug pricing and fraudulent accounting attracted the attention of politicians and the Federal Trading Commission, which began investigating the company. By that time, however, Fahmi Quadir had already shorted Valeant's stock, which gradually fell from $257 apiece to $28. This is one of the most successful shorts in recent years. Quadir was not alone in riding this crash, however. It is estimated that speculators made around US$3 billion on the fall of Valeant shares.  
 

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