Short Selling

Short Selling

Short Selling

Going Short – What is Short Selling?

The term “Short Selling” originated in the stock market. A while back, a person borrowed stocks from his broker in order to sell them, and attempted to make a profit this way. As such, “selling short” or “short selling” was essentially selling an asset (stocks or commodities) that as an investor you were ‘short of.’ That is, an asset you do not own. The idea was that the underlying asset was considered expensive at present, and it was expected that it will be available at a more affordable price in the future. Today the term “Going Short”, or just “shorting”, has now been 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

As explained, short selling refers to borrowing stocks (usually from your broker) so as to sell them at the prevailing market prices, with the hope of buying them at a cheaper price in the future so as to ‘refund’ them. Short selling profits from falling prices is an inherently risky strategy to be applied in the markets. This is because, theoretically, stock prices have an unlimited upside so they can rise to infinite levels, whereas they can only tumble to zero (limited downside). This practically means that a short seller is exposed to unlimited losses, but with limited profit potential. That means an investor needs to be really sure about the demise of an asset in order to short it. However, as we saw in the case of GameStop, with a stock that was considered to be well on its way out, things can turn around and there is always a risk. In that case, it was a group of retail traders that got together on a forum to talk up the stock and increase its demand and therefore its price by buying it as a group. This meant that the Wall Street investors, such as the Hedge Funds, who had shorted this stock, were suddenly left with an inflated stock price, bringing them massive losses when they had to buy the stock back to fulfil the contract.

The Power of Short Selling

Although controversial, short selling is very integral in creating efficient markets. Shorting stocks creates liquidity in the markets by ensuring there are always enough sellers for long positions to be exited efficiently. Short selling also contributes to the fair price discovery of the underlying asset and can also help investors to allocate capital effectively in their portfolios. Without short-sellers, markets would easily be prone to financial bubbles while massive fraudulent activities would not be uncovered. This is because a short-seller looks at an underlying stock with a very critical eye so as to uncover negative fundamentals. In contrast, it is easy for an investor that goes long in a stock to perform lacklustre research or even be blinded by optimism and euphoria.

Speculative Short Selling and Short Selling as a Hedge

Short selling can be applied either as a speculative activity or as a hedging strategy. As a speculative activity, traders hope that massive profits will be booked when the price of the underlying stock falls. But most investors use short selling to hedge their long positions in an underlying stock. When hedging, investors essentially open an offsetting position to minimise their risk exposure in the market. Granted, hedging reduces risk, but it limits profitability as well. When prices of an underlying stock jump higher, the hedge position will incur losses, but the original long position will generate profits. Conversely, if the prices fall, the hedge position will generate profits, but the original long position will generate losses. Based on this, as a hedging strategy, short selling is an effective way of protecting your capital in the markets. This is similar to one of the primary reasons for investors to buy put contracts in the options market. That is, to offset the risks posed by their long position in the main stock market.

Despite the practical advantages of short selling, it remains a generally frowned upon activity. The criticism largely hinges on morality, with short-sellers celebrating when certain sections of an economy experience a bad moment. When you go short on a stock, you are placing a bet contrary to the majority of investors and are clearly expecting and wishing the underlying company to perform poorly. Short selling is also known to increase panic and anxiety levels among investors, which effectively worsens off sell-off periods in the markets. This is one reason why there is always strict regulation in various exchanges regarding short-selling activity.

In particular, it is ‘naked’ short selling that has been cited as a major accelerator of market downturns. While typical short selling involves selling borrowed stocks; naked short selling entails shorting a stock you do not own, have not borrowed nor have 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. In the US particularly, the SEC (Securities Exchange Commission) has continued to heavily regulate short selling activity, especially after the 2008 global financial crisis.

Despite the few concerns, short selling provides investors with interesting possibilities for both profiting in tough market conditions as well as mitigating inherent dangers in the market. Short selling can be very lucrative, but like any investment activity, it also carries a great deal of risk as well. To start with, short selling requires a margin account. This means that traders just need to place a small amount upfront so as to short sell a much bigger position in the market. This obviously amplifies their potential profits if the underlying stock loses value, but it can magnify losses as well, if prices of the underlying stock continue edging higher and higher.

To put this in context, consider that an investor buying stocks forthright stands to lose his entire investment if the price of the underlying stock falls; but a short seller can lose more than his initial investment if prices continue to drift higher and higher because theoretically, stocks can rise to unlimited levels.  Another major market risk for short selling is the short squeeze. A short squeeze occurs when the price of an underlying stock sharply jumps higher and short sellers scramble to cover their positions to prevent any further losses or risk exposure. With short sellers looking to cover their positions, the underlying asset experiences more and more demand, the underlying stock continues to experience tailwinds that push prices further up.

As mentioned earlier one example of a short squeeze happened in January 2021 with the shares of GameStop, a retail chain that sells video games. The company had weak fundamentals because it operates physical stores that sell video games in the digital age. But a discussion on an online forum, Reddit, prompted a massive influx of retail investor capital that was determined to punish big hedge funds shorting the GameStop stock. This saw prices jump from a measly $6 in September 2020 to over $450 by January 2021. This is a clear illustration that even if a short seller is right in terms of researching fundamentals, there exist some unforeseen risks of short selling that can result in massive losses in the market.

Another risk of short selling is that stocks generally move upwards over the long run. This means that short selling strategies cannot be implemented for the long term, and the market is typically very unpredictable over short periods. There is also the legislation risk, with regulatory agencies across different jurisdictions frowning upon short selling activity. It is possible that any relevant regulator can ban short selling of stocks in a specified sector or even a whole market to prevent selling pressure from piling up. This can lead to unprecedented rallying of affected stocks, which can lead to big losses for short sellers.

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 merchandise that is worthless 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.

Disadvantages of Short Selling

Here are some of the disadvantages of short selling in the market:

  • Short selling involves borrowing a stock to sell at current market prices. There are charges applied for ‘borrowing’ such stocks and this adds to an investor’s overall trading costs.
  • Short selling is conducted on a margin trading basis, which opens up investors to the risk of margin calls as well as margin interests incurred for holding trades over a long period of time.
  • Numerous other factors drive stock prices other than real company fundamentals. Situations, such as a short squeeze, make short selling an inherently risky strategy.
  • Borrowed stocks may be recalled by the respective broker with investors having no control over the prices prevailing in the market. This exposes investors to the danger of selling stocks at a price they do not agree with.

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.

Short Selling in Spread Betting

The same concept of short selling on regular trading, applies to spread betting. If one believes a certain instrument’s value will rise he can place £10, for example, for each pip the price moves. If, however, the instrument’s value is expected to decrease, he can place the same £10 for each point it goes down, and make the same profit.

Short Selling with AvaTrade

Short selling is a well-accepted trading method, and can be applied to all types of instruments, whether you trade forex, commodities, stocks, bonds and others. Since it enables you to trade and benefit also when the markets are down, it is important to find a CFD broker that has a well-established trading record, which will help you decide whether you should go long (buying) or short (selling). This, with a combination of over 250 instruments, that AvaTrade offers to its clients, provides countless trading opportunities and high profit potential.

Short Selling main FAQs

  • How can you manage the risk on a short sale?

    Because the potential loss on a short sale is unlimited it is critically important that traders work to proactively manage that risk. There are several ways to do this, including the use of a buy stop order to protect against the price of the underlying going up too much. An alternative is to place a trailing buy stop order that will follow the price of the underlying by the amount you specify and only trigger if the price goes against you. This allows you to let your winning short trades run.

     
  • Why would I want to sell short?

    Most people look to buy assets when the price is rising, but shy away from profiting from a falling price by short selling. However, there is nothing inherently wrong with making a profit from a falling price when you are bearish and believe the price will continue falling. This is especially true for short selling with CFDs where you aren’t actually selling the underlying asset, but are instead speculating on the changing price only.

     
  • What is naked short selling?

    A naked short sale is the illegal practice of short selling shares that do not exist. Typically, in short selling the trader must first borrow shares in order to sell them short. But with naked short selling there are no shares borrowed and so the short sale puts more short pressure on the stock that could be larger than the available tradeable shares. Naked short selling was made illegal in the wake of the 2008 financial crisis, but it still occurs at times due to loopholes in regulations and differences between electronic and paper trading systems.