08:58 AM, 02 Mar 2024 (AUS EST)   The market is currently closed       

Short Selling Explained: What is Short Selling

If you have been investing longer than a week, no doubt you have already heard of the terms ‘bull’ and ‘bear’, ‘long’ and ‘short’. Most people that have turned on the news already know that a bull market is one that is rising and a bear is when a market falls significantly. Simply buying stocks is considered going ‘long’ in the market as ownership of shares are assumed. But what is short selling? Why do we care?

Why We Care About Short Selling

The market goes up and the market goes down. Traditionally we make money and then we lose some with each cycle. But what if we made money when stocks go up, and we make more money when the same stocks go down? That way we could make money virtually 100% of the time. Is this just a dream? This is a reality with short selling.

Short selling allows an investor to make money on both sides of the market action.

What is Short Selling?

Almost everyone understands the simple concept of buying shares and selling them later. But what exactly is short selling? This is when you sell stock you do not even own. How is that possible? Under what set of circumstances are you allowed to sell stock that you do not possess? In a nutshell, you borrowing someone’s shares and selling them on speculation. Let me illustrate.

Short Selling Explanation

Imagine that the market for stamp collecting is really hot. You have a friend that has a large collection of very rare stamps. Sure, you can go on Ebay and purchase these stamps. But you do not want to buy them since you expect the market to drop. Buying and selling later would create a net loss. You want to sell your friends stamps for him and replace them later when prices drop.

You approach your friend and ask, “I have a proposition for you. I want to trade your stamp collection. If at any time you want your stamps back, I swear that I will go out and buy the identical stamps and replace every last one. This is a no risk situation for you. In fact, I will even pay you a small amount for loaning me your stamps.” You friend thinks about this for a minute and then agrees, provided you draw up a binding agreement. It is a winning situation for him since his collection usually just sits in a vault and gathers dust. Now you have a commodity to trade with. You are not the rightful owner or the stamps, but you merely loaned them with a promise to give them back later.

Next you hit the collector shops and stamp clubs. You sell the rare stamp collection for the market price. The money you receive from the trade is put in the bank where it collects interest. You can use the interest to pay your friend the small stipend for borrowing his collection. Then you wait, and wait. You hope and pray that the prices of stamps go down in price over time. If they do, you will go out and repurchase the exact same stamps for a lower price. You keep the net difference and return the collection to him. If prices go up, at some point you will need to dip into your own savings and repurchase the stamp collection at a loss before giving them back to the rightful owner, your friend. Thirdly, your friend might ask for the stamp collection at any time, thus you will need to repurchase them at whatever the market value is.

Short selling stock is exactly the same with the exception of a broker being the middle person. You approach the broker when you think a stock will drop and you want to sell it without buying it, that will come later. The broker will find someone willing to loan his shares out for a small amount of interest. You will then sell those shares and be credited the money. If the prices go down, you can repurchase the shares at a lower amount and return them to the original owner. You gain. If prices go up, the broker may get nervous that you don’t have enough money to buy back the shares. He may require additional margin or money kept with his firm to make sure you are good for the repurchase. You will either add margin, or at some point you will repurchase the shares at a loss. Finally, the person loaning you the shares wants them back, you will need to repurchase them on the open market. Then you will need to find someone else willing to loan their shares to you, if you still think the stock will go down.

How to Short Sell a Stock

The procedure is really quite basic. You imagine a stock will go down in value. You wish that you could sell at today’s high prices, and somehow buy them at tomorrow’s potentially lower prices. This is how it works.

  1. You go to your broker and ask to sell some shares of a stock you do not yet own. He looks in his inventory and sees that one of his other clients does have shares of the stock. You can borrow them and sell them now if you promise to replace them later. You agree.
  2. The broker will hardly take your word as collateral. So he will want a certain margin as a guarantee. This way if the stock jumps up in value the broker will have some money on hand to cover the difference.
  3. You wait and wait. If the shares go down in value you have the option of buying them back at a lower price and pocketing the difference. When you repurchase the shares and give them back to your broker, he replaces them with the client.
  4. If the shares go up in value (which is bad), your broker will look at how much capital you have as margin. He may make a margin call which requires you to add more capital with your broker. You should only continue to add margin if you believe the stock will go down soon. If the stock is now trending up you can close out your position at a loss.

Some particulars to keep in mind while short selling:

  • You sold stock you do not own. The lender still has rights. You must hand over all dividends and rights.
  • The lender has the right to ask for his stock back at any time. If the short position is ‘called away’, you will need to repurchase shares and cover the position immediately.

Why Short Sell a Stock?

Obviously you short sell a stock when you anticipate a price drop. There are two major categories of short sellers: Speculators and Hedge funds.

  • Hedging - This refers to a process of protecting your assets against a fall. Hedging is not always an active process of making money, but more of a protective strategy to retain as much earnings as possible. For instance, you may have a large position of a certain stock. Suddenly the market begins to tank and you panic. How will you protect your assets without selling? One method is to purchase Put options. If the stock tanks, you have a contract that will allow you to profit from a short sell transaction. There are many ways to protect your portfolio with hedging but much of it includes either directly or indirectly selling short.
  • Speculating - This is what the bulk of traders do. They look at the market, try to forecast a direction, and then take up a position. In fact, all investors could be said to be speculators of some sort. Even in the above example, the speculation is long and the hedging is short to protect that position. In another example we could speculate by shorting shares but hedge the position by investing long in others.

    Short selling might also be performed by certain options sellers. If they have a short sell position, they are able to write Put contracts against it. For example, imagine the stock is in a slow decline. A trader might short sell 100 shares of a certain stock. Then he might sell Put contracts to earn an income.

Know the Rules to Short Selling

Before you run out and try to short sell, you will need to familiarize yourself with the local country rules. The SEC has employed a bunch of different rules on short selling at different times. Some of these have included:

  • Waiting for stock to trade up one tick before short selling. This was to prevent negative momentum from crashing a stock.
  • Banning the short sell of certain stocks such as banks during the 2008 financial meltdown.
  • Banning naked short selling on the Australian stock market.

Of course, rules change. On 25 May 2009, ASIC removed the ban on covered short selling of financial securities. Other changes will need to be kept up with and you can see the ASIC rules on short selling here. As a side note, covered short selling refers to someone owning the shares that you are borrowing. Naked short selling is when shares are sold without the consideration of where they are coming from. It is possible that more shares are sold than really exist.

Risks of Short Selling

Although short selling can be highly lucrative, there are some risks that make this more dangerous than investing long. What are the risks?

  • Infinite losses
    When you purchase shares you cannot lose more than you buy with. The losses with short selling can be infinite. If you theoretically sold short at one dollar and the stock rockets to 100 dollars, you are out 100x your money. If you sold short 10,000 shares, you now owe 1 million dollars. The stock could go higher than that too. Of course, if you do not have appropriate margin on hand with the broker he will sell your position for you. He would never allow such a bill to rack up.
  • Stocks go up
    Just look at a long term chart for 30 random stocks. In general prices rise. This is true due to inflation if nothing else. Because of this, the odds are stacked against you in short selling. On the other hand, if you have a valid reason for the stock to drop then this is different.
  • Short squeezes
    The stock might jump in value. Normally you could weather this storm. Very likely there are other short sellers other than you. They could panic and start to cover. This increased buying makes the stock shoot up very rapidly. Remember what happened to Volkswagen not so long ago as prices jumped up almost 4 fold overnight.
  • Irrational Markets and Timing
    You may have a great method for valuating stocks. Perhaps you can prove that a stock is highly overvalued. The question is: when will sentiment turn if ever? The markets might continue to jump higher and higher with euphoria. If they do, you will need to close your short position out at a loss. Even if you are correct that a stock is overvalued, you will need to have the right timing. Timing requires a careful study of the charts and much technical analysis. A long investor with an undervalued stock can buy and forget about it for a few years until it goes in favor, a short seller does not have the same privilege.
  • Borrowed money and without ownership
    If you purchase a stock you own the shares. You can wait for 50 years to see if prices rise. As well, the money invested likely was spare cash. When shorting, you are trading on margin or borrowed money. This leveraged trading can often lead to bigger losses. As well, if the trade goes against you, it is closed out and you have nothing but a bad memory to show for it.

Is Short Selling Ethical?

Critics will claim that selling short will exacerbate a falling market. Some will view short sellers as the evil that pound a market down and prey upon the hides of a good companies misfortune. What is the truth?

  1. Selling short does not mean driving a stock down without ever having to repurchase shares. You do need to cover the open position. The same could be said of irrational buying of shares. With a reduced float the stock is much more volatile and can shoot upwards very fast. But nobody complains since its ‘money for everyone’.
  2. Short selling adds liquidity to the market. Imagine the frustration of trying to buy shares and nobody is willing sell. There could be a massive spread between the bid and the ask. Short sellers provide those needed shares and will close the trading gap.
  3. Short selling creates checks and balances between company and shareholder. A short seller is actively looking for bad practices by management. We could even view short sellers as helping the ASIC keep on the watch for financial foul play.
  4. Short selling is an important factor in fairly valuing stocks. Investors now have the ability to bring overpriced stocks down to more accurate valuation levels by short selling.

Selling first and buying back later is a legitimate way to trade. Both shorting and buying are fair practices in the market. Both can be carried out to the benefit of the market with the above noted advantages or both can be used in underhanded manipulative ways that give all traders a bad name.

Conclusion on Selling Short

For those interested in making money or hedging when the market drops, selling short is an excellent method to do so. Traditionally, short sellers have a bad name but by and large it has not been earned. Unscrupulous people exist in all facets and groups, and short sellers are no different. Although ‘pump and dump’ scams are prevalent, all long investors are not categorically lumped into this seedy practice. So to be fair we should distinguish the practice of short selling and the market manipulators that prey upon others.

Short selling does inherently carry more risk than investing long. A short seller will need to time his trade with the technicals of the market. For those who learn how to short sell, the upside can be very profitable.