Short selling is the act of selling a financial instrument (assets that can be traded E.G., stock, bonds, options, etc.) which the seller does not directly own with the intent to purchase it back later at a lower price in order to generate a profit.
Example: Theoretical company XYZ’s price per share is $100 and is then trading at $80 a week later.
An investor/speculator who believes the price will go down will SELL a share at $100 and receive the proceeds and then BUY the share back in a week’s time at $80, which leads to a net gain of $20.
An open position is when a trade has been established, regardless of the initial direction (E.G., buy or sell first) while to close a position means to terminate the standing open position. In normal circumstances closing a position is actioned by placing the opposite trade that occurred during the opening of the position to return to a neutral state (Example: sell if the open position was a buy and buy if the open position was a sell).
In financial markets, buying and selling can also be referred to as long and short positions respectively. In the context of share trading, taking a long position means an investor has bought and owns shares in a company in an attempt to profit as the value of the company rises while on the other end a short position is one in which an investor sells shares of a company (that they do not own) in an attempt to profit as the value of said company declines. The example in the previous positions paragraph could also be written as “short if the open position was a long and long if the open position was a short”.
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).
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 which over a period of weeks caused the share price to rise from approximately $20 to $325 near its peak.
It is important to note, unlike buying or going long, the loss potential on a short share position is unlimited. In the case of buying, the loss an investor can incur is limited to their initial outlay, for example buying one share of a theoretical company XYZ for $100 would mean the company going bankrupt would reduce the value of the share to $0, hence a $100 loss maximum in this circumstance. However, if an investor shorted company XYZ at $100, they would profit in the situation where XYZ’s value drops below $100 all the way to $0 as they will be able to buy the share back at the lower price to lock in the profit but will lose in situations where the price of XYZ rises above $100 as they will purchase the share back at the higher price. Thus, if the value of the company XYZ went to $200, they would purchase the share back and incur a $100 loss or if it reached a $1000, they would then incur a loss of $900 when they purchase the share back. As there is no limit to how high the price of company XYZ’s share could go, further losses to those levels can be incurred.
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).
Other entities such as CMC Markets and IG Markets do offer shorting through derivative instruments such as Contracts for Differences (CFD) and Options Contracts but this introduces another subset of rules and risks.
As CFD and Options contracts are considered complex financial instruments, we will not expand further upon each but ensure that you are thoroughly educated before you utilize them within your portfolio as we would not recommend their use for novice investors unless assisted by a professional.
Here at Halo Technologies, we believe in long-term global investing, thus, shorting is not offered within our platform. However, Interactive Brokers does offer the service of the traditional kind, meaning other solutions such as CFD and Options are not required but the user experience of the platform is catered towards experienced investors and is not recommended for novices.
Alternatively, for many people the simplest and least risky method of benefitting when a security price falls is through the use of a short/inverse exchange traded fund (ETF). One example of such an ETF is The ProShares Short S&P 500 (SH) which is the largest inverse ETF in the world with approximately $2B in assets under management (AUM) as of March 2022. The fund’s objective is to seek daily investment results, before fees and expenses, that corresponds to the inverse (-1x) of the daily performance of the S&P 500 index (Standard and Poor’s 500 tracks the performance of the five hundred largest companies listed in the United States). The ProShares UltraShort S&P 500 (SDS) and ProShares UltraPro Short S&P 500 (SPXU) are also available which are leveraged to provide -2x and -3x the return of the daily S&P 500 performance respectively, however, they are not recommended as long-term holdings. These ETFs and others are traded like traditional equity securities and are available at most brokers, including Halo Technologies.
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).
If you are interested in additional information on these events, detailed explanations can be found online or for an entertaining depiction we recommend:
*Note: Information is relevant to Australian individual/retail investors and may not be accurate for institutional and sophisticated investors.
All information contained in this publication is provided on a factual or general advice basis only and is not intended or be construed as an offer, solicitation, or a recommendation for any financial product unless expressly stated. All investments carry risks and past performance is no indicator of future performance. Before making an investment decision, you should consider your personal circumstances, objectives and needs and seek a professional investment advice. Opinions, estimates and projections constitute the current judgement of the author as at the date of this publication. Any comments, suggestions or views presented in this communication are not necessarily those of HALO Technologies, Macrovue or any of their related entities (‘we’, ‘our’, ‘us’), nor do they warrant a complete or accurate statement.
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