How a Short Seller's Account Went to Negative $106K

(From: Investopedia)

Joe Campbell, a 32-year-old small-business owner from Gilbert, Ariz., liked to trade the stock market in his spare time, but recently got caught in a disastrous trade he will never forget. The story of his devastating short position in KaloBios Pharmaceuticals Inc. spread like wildfire in the financial press, after he described on a crowdfunding website how his $37,000 account balance quickly turned to negative $106,000 on the heels of unexpected news.

KaloBios in Trouble

KaloBios Pharmaceuticals, which develops antibody-based drugs to treat cancer, announced in a Nov. 13 press release that it planned to wind down operations because of limited cash resources. The release also stated that it had engaged restructuring firm Brenner Group to assist with the liquidation of company assets. The negative news attracted the attention of short sellers eager to profit from a further decline in the value of the company’s stock.

The Short Trade

Campbell was among the short sellers hoping to profit from the company’s demise. On Nov. 18, he sold $33,000 in KBIO stock in his E*Trade Financial Corp. account at an average price of about $2 a share. He then went into a work meeting, planning to hold the position overnight. He stated on his GoFundMe page: “I was holding KBIO short overnight for what I thought was a nice $2 fade coming.”

After the close of trading, KaloBios issued a press release announcing that “an investor group comprised of Martin Shkreli and associates together have acquired more than 50% of the outstanding shares of KaloBios, and that the company is in discussions with Mr. Shkreli regarding possible direction for the company to continue in operation.” (Shkreli, a hedge fund manager and entrepreneur, is the founder and chief executive officer of Turing Pharmaceuticals. He stirred up controversy in recent months after his company dramatically raised the price for a drug used to treat AIDS and cancer patients.)

KaloBios' Stock Soars

KaloBios Pharmaceuticals' stock soared by as much as 800% in extended hours trading on the news of Shkreli’s investment. When Campbell got out of his meeting, he received a message from a concerned friend who knew that he was short KBIO. At first he worried that he may have lost his entire account of $37,000. He quickly learned that the situation was even worse: The stock price had spiked to $16, and his account was now negative by over $100,000. After he called E*Trade, his short position was covered at an average price of around $18.50, resulting in a negative balance of over $106,000.

The stock continued to rise and surged the following week, after Shkreli stated on Twitter that he wouldn’t sell any more stock to those looking to short sell it, stating: “I spoke with my counsel & advisers and decided to stop lending my $KBIO shares out until I better understand the advantages of doing so.”

Because Shkreli owned such a large proportion of the shares outstanding, his decision made it hard for remaining short traders to exit their positions. The situation was reminiscent of the 2008 short squeeze in Volkswagen, when Porsche increased its stake in the company. Volkswagen’s stock price rocketed higher and short sellers struggled to cover their positions because of the lack of supply in the stock.

Crowdfunding Campaign

Reacting to the devastating loss, Campbell quickly launched a GoFundMe campaign asking for help with his massive margin call.

He was at least partially conscious of risk, stating that the $37,000 in his account was capital that he could afford to lose. He made it clear on his GoFundMe page, however, that he had made the false assumption that there was a safeguard in place to prevent his account from going negative: “Never in my wildest dreams did I imagine that Etrade would NOT have some sort of stop or circuit breaker in place that would automatically cut a position if the account went to $0.”

He ended by saying: “My plan moving forward is to liquidate mine and wife's 401k's and try work out a payment plan with Etrade. What an expensive lesson that was. I hope my story helps someone else from the same.”

The page received a range of responses from sympathetic to harshly critical. However, he was able to raise over $5,300 through 151 donations before removing the campaign.

The Bottom Line

Campbell’s trade was a highly risky one in three ways. First, it was a short trade without any hedge. With short sales, potential losses are theoretically infinite, because a stock price can continue to rise and rise. In the case of a long position, losses are limited because the price of a stock can only go to zero. Second, his trade was in a very low-priced stock. Penny stocks and those priced very low often see high levels of volatility. Finally, he held the position overnight when there is less liquidity and limited access to the market, making traders even more vulnerable to events such as unexpected news releases.