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What Is Short Selling?

Views 7752022.12.20

The key takeaways

The stock market attracts all kinds of investors, from conservative, long-term thinkers to those looking for creative ways to turn a profit. With so many different investment strategies available to investors, learning about varying approaches is a strategic way to maximise your investment opportunities. If you’ve never heard of short selling before, it’s time to get familiar with the term.

What is short selling?

Short selling sees investors borrowing a security from their broker that they believe is going to fall in value. They then sell it on the open market, before buying the same stock back later at a lower price than it initially sold for. The difference, after the initial loan is repaid, forms a profit.

If a stock was trading at $10 a share, and an investor borrowed 100 shares, they could sell them for $1,000. If the price then declined to $5 a share, the investor would then purchase 100 shares at a cost of $500. The investor can then return the borrowed shares to the broker, while netting the difference in the sales price and the purchase price.

Why is it called Selling Short?

The term ‘short selling’ comes from the short position an investor takes when they bet against the market, hoping to make a profit when prices decline. This is in opposition to a long position, which involves buying an asset in the speculative hope that the asset’s price will rise. One easy hack to remembering the difference is to remember that a long position relates to the potential for long-term growth, more often than not, while a short position is about a faster return through a sinking stock value.

Why Sell Short?

Selling short is commonly undertaken because of speculation, with investors hedging their bets against the market. An investor who’s short selling is making a bet that the price of the share of their choice will decline in the future. This can be an inherently risky proposition - if the market doesn’t turn in the direction they’ve anticipated, they’ll need to buy the shares back at a higher rate than they sold them for, creating a loss.

Short sellers are most likely to conduct their sales within a smaller time horizon because of the additional risks in short selling. Some investors will also sell short in order to hedge their long position, with the ability to lock in profits short selling for those who own call options. Investors may also choose to limit downside losses without exiting a long stock position through selling short in a stock that’s highly related to their existing long stock position.

What can you Sell Short?

Short selling involves the sale of equity stocks which aren’t owned by the seller, but are borrowed from a broker for the purposes of a short sale. The investor pays the broker interest until the stocks are replaced.

An equity stock is a stock or any other security that represents an ownership interest in a company. This gives investors a wide range of short sell opportunities across varying stock markets.

How does Short Selling work?

Short selling requires the borrowing of a stock from a broker, with a shared agreement that the stock will be replaced by the time of settlement. The investor then sells that stock, knowing they’ll need to close the position by replacing that stock through purchasing more in the future. Simply put, this allows investors to sell the stock when it’s worth more, and replace it through a fresh stock purchase when it’s priced lower in the market. The risk remains that the stock won’t drop in price, but may rise, at which point a short seller would need to make a loss via the replacement of that stock at a higher price point than they sold it for.

Risks and Rewards in Short Selling

There’s no denying that short selling can be a risky proposition, given the need to replace the borrowed stock by the time of settlement with the lending broker. If you’re considering entering into the short selling market, it’s important to be aware of the risks involved. This can assist you in making informed decisions about which stock you believe is worth shorting in order to turn a profit.

Understanding the risks

There are a number of risks that come with short selling. In traditional long investing, an investor only risks losing their initial investment - even if the stock continues to fall in value, they’ll never lose more than the cost of purchasing that stock, resulting in a lowest potential value to that investor of $0, no matter their purchase price.

When an investor sells short, on the other hand, there’s theoretically no limit to how much they could lose. If they’ve short sold a stock, that stock’s price could continue to increase without limit.

Investors who choose to short sell also face the risk of a short squeeze. A short squeeze occurs when a stock with a large short interest (one which has been heavily sold short) then experiences a rapid climb in price. As a large number of investors need to buy back stocks, a steeper price is triggered as they rush to close their short position and limit their losses.

Advantages

Short selling can be advantageous for investors who are looking to serve the purposes of speculation or hedging.

Speculators use short selling to capitalise on where they believe there’ll be a potential decline within either one specific stock/security, or across the market as a whole.

Hedgers employ the strategy of short selling in order to protect their gains, or to mitigate their losses across one security or portfolio.

It’s not uncommon for even institutional investors to engage in short-selling strategies, with hedge funds taking position amongst the most active short sellers.

Short selling can give investors an opportunity to make a profit even within a declining or neutral market, as opposed to the traditional growth needed for long investment strategies.

Disadvantages

Short selling comes with a number of potential disadvantages, meaning it’s best undertaken by experienced and sophisticated investors.

Short selling can have limited effectiveness, as short selling investors only see a profit on the back of falling markets. As markets have prices that both rise and fall, focusing only on prices falling can limit the ability for that investor to see a profit with other investments or strategies.

Short selling is also, understandably, a high risk investment approach. This is due to the limit in profit ranges - of the share price increases, the investor has to bear the difference between the old price and the new price, while still accounting for broker’s fees.

Investors who only short sell also lose out on the opportunity for dividends, and can experience panic if a stock price they’ve short sold begins to increase unexpectedly. This can increase the risk of market crashes if there’s a large amount of short selling on one particular stock that then goes up in price, rather than down. You can learn more about the dangers associated with short selling here.

Examples of short selling

Looking to take on short selling within your investment strategy? Here’s some easy examples that will help you to understand the potential benefits and risks of short selling.

Example of Short Selling for a Profit

In this example, an investor decides that a stock is expected to fall. They borrow 100 shares from a broker and sell them for their trading price of $100 per share. This results in $10,000 worth of sales.

The shares then fall to $60 within the market. As the investor needs to repay the broker the shares they borrowed, they purchase 100 shares at $60 per share, which costs them $6,000.

The difference between the sale price and the purchase price is $4,000. The investor’s profit is achieved once the broker’s fees are removed from this difference, creating a net profit.

Example of Short Selling for a Loss

In order to fully comprehend the risks of short selling, let’s take a look at an example of short selling that results in a loss.

If the same investor believes that stock is going to fall, and they borrow 100 shares from a broker, selling them for their trading price of $100 per share, this still results in $10,000 worth of sales.

However, instead of the share price then falling, it rises. Now, each share costs $110.

The investor must now buy back 100 shares at the new price of $110. This costs them $11,000. This investor has now lost $1,000 as a result of buying back borrowed shares at a higher price than their own sales price.

Costs of Short Selling

There are a number of costs involved in short selling that any astute investor must be aware of. These costs can make a significant difference to net profits, or can increase net losses should stock prices go up, rather than down.

Margin interest

Margin interest accrues if short positions are kept open for lengthy, extended periods of time.

As brokers charge interest on the loan of stocks, the length of time the stocks are borrowed impacts on the total amount of margin interest incurred. Each broker sets their own interest rates depending on differing loan amounts, and these rates are subject to interest rate increases and decreases.

If an investor is looking to short sell a stock that’s hard to borrow, this will often incur a higher fee.

Stock borrowing costs

When an investor borrows stock from a broker for the purposes of short selling, the broker will lend these stocks from within the pool of securities held by them or their clients. Commonly, there are two types of loans: call loans and term loans. Both of these loans incur costs owed to the broker.

Within a call loan, the lender can terminate the loan at any point in time. This is the most common type of loan, and can lead to associated risks for the borrower.

Term loans provide stocks for a specified period, often for one month.

Typical fees for stock loans are 0.3% per annum, but this fee can go up much higher in cases of short supplies.

Requirements, Dividends and other Payments

Even when an investor has borrowed a stock, the dividends that stock generates are owed to the lender, not to the borrower. Investors who are short selling stocks are never entitled to keeping its dividends. If an investor borrows a stock that is owed any declared dividend payments within the borrowing period, this must be paid to the lender.

Regulations

Short selling isn’t illegal, but does have regulations placed on it within different parts of the world.

United States

The United States has more of a liberal regulatory approach to short selling than most of the world. In the US, short selling is under the regulatory authority of the federal Securities and Exchange Commission (SEC). The SEC has historically placed temporary bans on short selling financial stocks during downticks, but long-term quantitative analysis have led to repeals of anti-short-selling regulations in 2007.

US investors need to understand the difference between short selling, which is legal, and ‘naked’ selling, which is illegal. In a ‘naked’ short sale, the seller doesn’t borrow the securities in time to deliver them to the buyer within a standard settlement period, resulting in what’s known as a ‘failure to deliver’.

Europe, Australia and China

Europe, Australia and China have varying regulations around short selling. In Australia, there is a limited number of approved ASC companies that are allowed to be sold short, with leveraged equities publishing a list of approved companies alongside the collateral requirements.

In Europe, a number of regulators banned the short selling of shares during the start of the COVID-19 pandemic, with France, Spain and Italy issuing one-day prohibitions against betting on falling share prices for selected companies. These turned into longer bans that are applied to all stocks listed on their domestic markets. This was in order to protect the market during the rapid uncertainties of the COVID-19 financial environment.

In December 2021, China authorised insurers to take part in securities lending, leading to an increase in short-selling activities. China has continued to relax its short-selling rules since its crackdown in 2015 during the stock market crash.

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