Short selling is the practice of opening a position that will increase in value if a financial instrument’s price decreases. This position is opened by borrowing shares of a stock or other asset that the investor believes will fall in value.
The investor then sells these shares to buyers that are willing to pay the market price and buys them back at a lower price following a decline before the borrowed shares have to be returned. The investor then keeps the difference between the price they sold the shares for and the lower price they brought them back at.
A short seller is a bearish investor. They borrow funds from a brokerage on margin, it’s a high-risk way of investing, but can bring high rewards. That’s why it’s more likely that hedge funds will short stocks, rather than individual investors.
Jim Chanos of Kynikos and George Soros are among the world’s most famous short sellers. Chanos helped expose Enron and Soros bet against The Bank of England when he shorted the British Pound. In recent years the film The Big Short brought Michael Burry to fame. Then there was David Einhorn, who shorted Lehman Brothers.
How short selling works
Most people, when they think of the stock market, understand it to be a place where you buy shares in a company, wait for them to increase in value and ultimately sell them to make a profit. In this case, the buyer is ‘bullish’ because they believe the value will increase.
If the share price loses value, you sell them at a loss, or hold on, hoping for them to eventually recover. That is a basic overview of how the stock market works, but there’s actually a lot more to it.
Short selling is the opposite of this because it involves betting against the company, that’s when the investor is ‘bearish’ because they believe the company share price will fall.
In a nutshell:
- The short seller borrows the stock from the broker, e.g. 1000 shares of GameStop.
- Then sells these shares at the current market rate of $17 for $17k total.
- They set a specific date for when they think the GameStop share price will go down e.g. in one month.
- Then they buy back the stock at the lower rate of $15 for $15k when it falls.
- They return the borrowed stocks back to the broker.
- Keeping the difference of $2k as profit.
While the hedge fund holds the borrowed stocks, they pay the broker interest and commission fees. But if the stock doesn’t fall as predicted, then they’re on the hook for an increasing amount of money.
In the case of a short squeeze, if the price escalates rapidly, the broker will demand the shares are returned. This is a margin call and forces the hedge fund into buying back the shares at a much higher price.
The difference between buying and shorting stocks is the amount you stand to lose. While a buyer of a stock can risk their full stake if the stock goes to zero, there is no limit on the amount a short seller can lose.
Advantages of short selling
The advantages of short selling include:
Potential high profit
Although a risky investment tactic, If an investor’s predictions and analysis is correct there is the potential to make very high profits from short selling. The profit is determined by the difference between what they opened the short sell at and what they closed at.
Little initial capital required
As the investor is borrowing the stocks from a broker for a specified amount of time before they return them, they do not require large amounts of capital to open their short sell position with the purchase of the stocks.
Hedging against over holdings
Short selling can be used to provide additional risk protection for your overall investment portfolio. Experienced investors often use short positions to hedge long positions that they hold for a better return.
Disadvantages of short selling
The disadvantages of short selling include:
Potential unlimited losses
When it comes to short selling the losses you can make if your analysis and predictions are wrong can be limitless. If the stocks increase in value, the broker may recall the borrowed stock. This is a margin call and forces the investor into buying back the shares at a much higher price. There is no limit to the losses an investor can incur in short selling.
Investors need a margin account
To open a short position, the investor will be required to have a margin account and will often also be liable to pay interest on the value of the borrowed shares for as long as the position is open. As the investor is essentially investing with borrowed money, they are using leverage which can magnify losses.
Regulators can impose bans on short sales in a specific sector or in some cases in the broad market. This is done to help avoid panic and selling pressure. But doing so can cause a sudden surge in share prices, leaving the short seller to cover short positions at massive losses.