Short selling equities and Exchange Traded Products such as ETFs and ETNs are usually a relatively safe and straight forward process for educated investors but there are times when short selling can be a significantly more volatile and risky trade than normal long buying. Recently Credit Suisse’s VelocityShares Daily 3X Inverse Natural Gas ETN’s (DGAZF) stock price rose more than 2000% and short sellers incurred -$2 billion in mark-to-market losses. DGAZF is the 15th most shorted domestic ETF\ETN with $2.1 billion of short interest; 140 thousand shares shorted; 45.94% of its float and a 19% stock borrow fee.
DGAZF’s recent black swan price move in an illiquid trading environment has forced regulators to suspend trading of the ETN. DGAZF has been trading at a significant premium to its underlying assets for quite some time but it reached an exorbitant level when 1 share traded at a price of $25,000 on August 12th. With a net asset value between $120-$125/shares this was a 200X premium to its underlying holdings.
Trading in the afternoon of August 12th were only small lots (most trades were less than 10 shares\execution). Such trading points to either algorithmic trading trying to exploit the premium arbitrage in the ETN or short sellers trying to cover their open positions in a very imbalanced bid\offer market. With trading so illiquid and the bid\offer order imbalance so extreme, long sellers were able to drive up DGAZF’s price. Shares closed at the $15,000 level in the 12th.
DGAZF short sellers had an average short interest of $117.4 million from January 1st through August 7th and were down -$111.3 million in mark-to-market losses for the year. On August 7th DGAZF short interest was only $100.0 million but the ETN’s price move from $720.05\share to $15,000\share created -$1.999 billion of mark-to-market losses … a -1,999% loss in less than a week. DGAZF short sellers were down -$1.68 billion in mark-to-market losses on August 12th alone.
In a press release Credit Suisse announced it would be accelerating the maturation of the DGAZF ETN to August 25, 2020, effectively an early termination of the ETN. The final pricing of the ETN will be according to its Pricing Supplement, which will be the average closing price of the ETN during its Accelerated Valuation Period August 14th – 20th, 2020.
Short sellers will be trying to close out their positions during this Accelerated Valuation Period if there is enough liquidity to trade into. There are 140 thousand shares shorted in the ETN, short sellers are hoping that there is more trading activity over the next five days than the less than eight thousand shares traded on a daily basis in July and August. Shorts are hoping that there are enough long shareholders looking to sell their positions before the final pricing of the ETN on August 25th that they can buy to cover at less inflated prices. It is unlikely short sellers exit their trades unscathed, as it is unlikely DGAZF’s price falls back to “normal” levels by August 25th.
Perennial volatile stocks like Tesla (TSLA) and sudden volatile stocks like Kodak (KODK) and DGAZF highlight the need for strong risk management when shorting stocks. Using a system like our Blacklight SaaS platform that aggregates and normalizes positions that are on multiple trading platforms allows traders to manage their positions on one screen. TSLA shorts had 18 days of price movements over +\- 10% which created large swings of profits\losses but did not necessarily put a firm\investor out of business. But the +203% and +318% daily price moves in KODK and +223% and +400% moves in DGAZF were potential widow makers.
While a long shareholder can only lose what they invested or borrowed, a short investor’s losses can technically be infinite. As we see in DGAZF and KODK these losses can be sudden and massive. Short selling is a useful tool in an investor’s trading arsenal to generate Alpha in downward trending securities or creating a hedge for a long portfolio, but an investor must be aware of the associated trading risks. Being long or short in illiquid stocks creates “exit” risk, the inability to close out your position due to lack of trading volume. Exiting a long or short position which is a large portion or significantly larger than average daily trading volume will move the security’s stock price and eat into your mark-to-market profits or add to your mark-to-market losses. At the extreme, like DGAZF, an investor may not be able to close out their position since there are no takers on the other side of the market.
When trading in illiquid securities the age-old proverb goes both ways, Caveat Emptor and Caveat Venditor, both the buyer and seller beware.
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