What is Short Selling? The term “Short Selling” originated in the stock market. A few years back, a person loaned stocks from his broker in order to sell them, and attempted to make a profit. Today the term “Going Short”, or just “shorting”, was adopted in the trading world, and it means selling an instrument. Respectively, buying an instrument is called “Going Long”, or just “Long”.
How to Short a Stock
At its most basic form, shorting a stock occurs when an investor or speculator borrows shares of a company from an existing owner (usually a stock broker) and sells them at the prevailing market price. This is done, on condition, that the shares would be replaced at some point in the future. Short selling stocks is done with the hope that prices will decline in the future.
On the contrary, when buying stocks, investors or shareholders hope for the continued success of the company, which would lead to the appreciation of share prices and consequently, generate wealth for them. Theoretically, there is an unlimited upside to where a share price can go. This inherently makes short selling a risky endeavour.
As a result, short selling is only done on a margin basis, where investors put up part of the total capital outlay and borrow the rest from the broker. This can be a double-edged sword; traders stand to pocket huge profits if the prices drift lower, but can also lose a lot, even with marginal price increases.
In a market dictated by demand and supply, short selling carries with itself a risk known as a short squeeze. A short squeeze occurs when a stock does not fall as expected. When this happens, short sellers begin to buy stock to cover their short positions. More and more short sellers begin to panic and follow suit to cut their losses. This generates massive buying pressure that only serves to drive stock prices even higher.
But large traders (usually hedge funds) curb the risk of short selling by short covering. Short covering is the practice of buying stocks to ‘cover’ or hedge an open short position. Short sellers expect prices to go down, but if they go up, they can decide to lower or eliminate their exposure to the short position.
This allows traders to protect themselves against an unexpected market move. Essentially, short covering puts traders in a neutral market position; but with proper and expert timing, both positions can be exited with minimal profits, without any risk involved.
Short selling will always be a controversial issue because morally it means one is betting on the fall or even death of a company. But financial markets are cyclical in nature, and there will always be opportunities of when to sell stocks.
This can be when there is an overall bear market; or when an investor wants to hedge a portfolio; or when there is a chance to take advantage of knowledge about a particular stock. Still, short selling remains a risky and aggressive investment strategy; and in some cases, it can lead to disastrous market consequences. It is always said that aggressive short selling can sometimes turn normal market corrections into full-blown bear markets.
This is why there are usually restrictions on short selling, especially naked short selling, in many exchanges. While conventional short selling involves selling a stock borrowed from an owner; naked short selling entails shorting a stock you do not own, have not borrowed nor positively determined that they exist. This could mean that a seller may fail to deliver the shares to a future buyer and this can lead to market distortion. In the worst-case scenario, naked short selling can even lead to a market recession.
Advantages of Short Selling
Short selling has many advantages that attract many traders, new and experienced alike:
✓ Short selling grants traders access to instruments that they would otherwise not be able to trade. If one wants to benefit from a decrease in an instrument’s value, he can do it without owning it.
✓ Going short on an instrument, meaning opening a selling position on the platform, allows traders to benefit even when the markets are going down, as will be explained in the example later.
✓ Short selling minimises the risk the trader takes. There is no need to buy and sell instruments in “real life”, rather trade them electronically and profit from the fluctuations. Moreover – should a person own crude oil, and its price drops dramatically and suddenly, the person is left with a merchandise that is worth less from the time he bought it, and without potential buyers.
✓ In short selling one can monitor and control his investment with the use of different market orders, stop loss and others. These can prove critical when short selling.
✓ Just like going long, one can employ leverage in short selling, and open positions larger than his capital.
Short Selling Example
Returning to this article’s favourite instrument – crude oil.
✓ Say its price when the markets open on Monday is $44.50.
✓ In regular trading, if a trader believes the price will rise, he will open a buying position, and if the price went up to $45.50, his profit is $1 for every unit sold.
✓ With short selling the trader can act as the seller; if the expectation is for the price to drop, he would open a selling position for this instrument.
✓ If the price got to $43.50, his profit is $1 and he can now close the position, meaning he “buys” the instrument for a better price.
However, these opportunities carry with them a significant risk. When you buy an asset, the maximum risk of your trade is that the asset’s price drops to zero and you lose your investment. When you sell an asset, its price could rise infinitely so there is no cap on your losses. For this reason risk management tools, such as “stops”, can be useful when short-selling.