Reading Buffett today.  He said something amazing.  Talking about the rise of the auto industry in the US, he said (paraphrasing):

“It’s not always possible to predict the winners. However, it’s often easier to predict the losers.  I’m disappointed the Buffett family didn’t hold a short position in horses.  We could have easily borrowed some if there was a short squeeze”

Shorting

In a short position, you are basically selling horses.  e.g. Owning -100 horses.    When the price goes down, you make money.  Then, you can buy more negative horses.  Let’s say a horse costs £100 today.  I sell 100, netting £100,000, but owing 100 horses.  In 3 months, the price declines to £90.  I buy 100 horses, learning the balance.  It costs me £90,000, leaving me £10,000 up.

So, to do this, I would have to borrow 100 horses in order to sell them.  (this assumes I can give back different horses… it would be different if these were specific horses).

Short Squeeze

So, what is a short squeeze?   This is where lots of people hold a short position, and the price of the horses increases.  Maybe it’s harvest time, or something.  In this case, the price might go up.  People with short positions might see their losses increasing and realise that they will go broke if they’re not careful.  

Brokerages have margin accounts.  This is money that you deposit with the brokerage to cover the losses of short-selling, if any accrue.  So, if you held a large short position, you might get a margin call on the account and have to give the brokerage more money. 

Let’s say the margin account balance was £5000.   If the price of horses increased to £105, your short position would be liquidated.  You would end up losing your margin of £5000, because you would spend the whole £105,000 buying back the 100 horses you owed.  (Ignoring options here, for simplicity).  

Otherwise, your short position would be closed before it was the brokerage rather than you that was accruing losses.

Borrowing More Horses

So, if the price increased, Buffet could borrow more horses.  And then, sell those horses too.  And pay more money into his margin account.  This would increase the size of his short position.  But, crucially, he would still be able to cover his margin calls.

He would then be paying borrowing costs on the horses (maybe £5 per horse-month?), rather than covering margin calls.  Arguably, this would be better – he would be able to “ride out” the squeeze.  But, if his long-term bet against the horse failed to pay off, he would be ruined.  

Possibly why his family didn’t do this.

Keynes:

     “The market can stay irrational for longer than you can stay solvent”