Short Selling Explained
Short selling is the act of selling a financial instrument (assets that can be traded E.G., stock, bonds, options, etc.) that the seller does not directly own with the intent to purchase it back later at a lower price in order to generate a profit.
For equities, a short trade is a way for investors to profit off the decline of a stock.
When you buy a stock, in most cases you are expecting the company to perform well and for the price to increase. This is known as going “long” on a stock.
On the other hand, when you “short” a stock, you expect the company to do poorly and for their price and value to decrease.
You can learn more about short selling with our short selling explained
What is short selling
Put simply, short selling shares is akin to you betting that a company’s share price will drop.
Even if you do not directly participate in short selling stocks yourself, it is important to understand which investments and entities are being shorted by other investors to better protect your capital.
How does short selling work
Short trading involves bets that the value of company portfolios will decrease.
To do this, a short trading firm will borrow a stock from a lender, sell that stock, and then purchase the stock back later to return to the lender.
If the price does decline after selling, the short seller buys it back at a lower price and returns it to the lender.
The profit is the difference between the sell price and the buy price.
A Real-World Example
Say an investor thinks that the price of a company is overvalued. The investor begins their research, begins the process and “borrows” one share from their broker at the current market price of $100.
The broker needs to find a share in this company and can look in their stock inventory, their client’s portfolios, or through other brokers.
Once the broker has located the share, they will sell it at the market price of $100 for the investor.
This is what’s known as creating a shorting position. If the investor is right and the value falls to $75, they can then purchase at this price and return it to the broker. The investor will receive the difference in profit, in this case, $25.
However, if the investor is wrong and the share price increases to $125, they can stand to lose the difference also.
Advantages of short selling
There are several advantages to this type of trading strategy.
To begin, short selling shares does not require a large amount of capital to start with. An investor can borrow shares from a third party and potentially start to see profits in a small period of time. It is important to note, however, stockbrokers will often charge fees for this sort of lending and transactions.
Short selling is often used for speculate or to hedge on a company or the market.
- Speculators can use the practice to capitalise on the decline of a company or the market. When facing a bear market, short selling shares is often one of the few trading methods which can generate a profit.
- Hedgers often use the practice to protect their capital by mitigating losses on a stock or a portfolio. Hedge funds often use selective short selling stocks to hedge their long positions in other markets. For investors in the fund, this can lead to reduced volatility and lower risk.
Disadvantages of short selling
Short selling on the ASX is a high-risk trading strategy that should only be used by experienced traders.
Traditionally, when an investor goes long (buys) on a stock, they only stand to lose the money that they have invested. This is because a stock price cannot fall below zero.
However, when it comes to short selling shares, there is theoretically no limit to the amount they can lose as a stock’s price can continually rise forever. As a result, the practice attracts a higher amount of risk.
Due to the high level of risk, the strategy can often be difficult for individual retail investors to participate in.
Requirements for short selling
Brokerage charges apply when you open and close a short (sell) position, similar to the costs you incur when you open or close a long (buy) position.
When selling shares that you do not own, it is a requirement that the position be “covered” meaning the seller borrows the same number of shares they are shorting from their broker for the duration that their position is open. A “naked” short sell is where shares are sold without them on hand or borrowed which was prohibited during the 2008 Global Financial Crisis (GFC) to curb volatility by the Australian Investments & Securities Commission (ASIC) with the restriction remaining up until this present day.
As a borrowing is taking place with the seller’s broker, a margin account is a requirement before the broker allows their customer to short sell. A margin account allows customers to borrow money against the value of the cash and securities (used as collateral) within their portfolio. The amount of borrowing available is based on the cash and loan-to-value (LVR) ratios of the individual shares held within the portfolio which means the figure is constantly in flux as daily share price movements affect their value.
Alternative to a margin account, the more common cash account is one in which long positions can only be entered when the funds are available for the purchase.
Additionally, as potential losses for the short seller are greater than their initial outlay, brokers require a buffer in portfolio value over the loan amount before a margin call is triggered. A margin call is when the broker requires the account holder to deposit additional collateral (cash or securities) into the account to raise the buffer back above the determined minimum level (maintenance margin) in the event the loan amount exceeds approved borrowing level which is commonly triggered when shares within the portfolio decline in value. If additional collateral cannot be posted, borrowing levels must be reduced to bring the account back into proper standing which requires selling of securities within the portfolio, if not actioned within a reasonable time, the broker will force liquidate portfolio holdings to meet the margin call with the selection of securities sold up to their own discretion.
Borrowing costs are required to be paid on short positions. The rate is usually dependent on the number of shares available to borrow for said company in question with a lower supply attracting a higher borrowing rate.
Furthermore, if the short seller holds an open position on a share over the cum-to-ex-dividend date (date in which shareholders are then entitled to a dividend), they will be responsible for payment of the dividend to the respective buyer of the shares (Example: a short seller borrows one share and sells it to a third-party who is now an owner of the share and is entitled to a dividend).
Is short selling on the ASX allowed?
The above-board and regulated practice, as described above, is permitted in Australia.Click here to read ASIC RG146 details on short selling
What is a short interest?
Short Interest is the total number of shares that investors sold in which the positions have not been closed out (does not include selling from investors who own shares) and is expressed as either a number or percentage. It is often used as a sentiment indicator with a high short interest indicating pessimism around the company in question. Tesla Incorporated’s (TSLA) short interest currently stands at 3.0% but in previous years reached approximately 25% (a percentage above 10% is considered high).
What is a short squeeze?
A short squeeze is the event in which a heavily shorted share rises rapidly in price, thus, a decision is made by short sellers whether they retain their position or close it by buying the shares back to minimize losses. As the sellers close their positions, the buying activity stimulates additional share price appreciation further adding to losses to short holders. At the end of 2020 and the beginning of 2021, GameStop Corporation (GME) was thrust into the limelight as it was targeted by the WallStreetBets sub-Reddit in which members invested into the company and created a short squeeze. Melvin Capital was a hedge fund that was short GameStop and in January, 2021, was losing over $1B a day and all up suffered a $6.8B loss overall or over half the fund’s value in the month. The fund is shutting down operations in June, 2022, due to ongoing losses.
Notable short selling case studies
Aside from the previously mentioned Tesla and GameStop events, other occasions in which short selling occurred includes the time when George Soros bet against the British Pound Sterling (GBP) and became “the man who broke the Bank of England” and earned $1B on his trade in 1992.
John Paulson is another investor who’s fund Paulson & Co. reportedly earned $15B during the Global Financial Crisis (GFC) in 2007 to 2008 by taking a short position on the United States housing market through the use of Credit Default Swaps (CDS).