Short selling is often undertaken by stock traders. It is the selling of a financial asset the seller does not own in the hope of buying it back at a lower price later. Short selling or ‘going short’ is a practice that can be undertaken in many financial markets including Stocks, Exchange Traded Funds, Forex, Commodities and Bonds. Shorting can be done through the stock market but also when trading Futures, Options, Contracts for Difference (CFDs) or Spread Betting. The concept can be a strange one for new traders and investors. Everyone is familiar with the process of buying an asset, selling it at a higher price and making a profit. A trader who buys a financial security is said to be ‘long’ or have a ‘long position’. Long positions are considered bullish. Short positions are considered bearish. In going short, however, the question arises as to how you can sell something you do not own.
A stock trader engaged in short selling will borrow the stock from a lending broker. The broker will charge a fee for this service and the seller has to return the stocks to the lender. Typically there is an agreed time frame by which the shares must be returned. The borrower holds the view that the stock price is going to decline in the near future. If they are correct and prices decline, they can then buy the stocks back at a cheaper price and return them to the broker.
Let’s take the example of a stock trader who borrows 10,000 ABC shares trading at $20 and sells them short. The share buyer has to pay $200,000 for the shares. The shares decline in price to $15. The seller buys them back and returns them to the broker. The cost of buying them back is $150,000 so the trader realises a profit of $50,000. Of course, this example does not include borrowing costs or commissions.
The risk to the investor is if the share price rises. Let’s say the price rises to $23. The investor may fear their analysis is wrong and decide to exit the trade before the stock rises any further. This is known as ‘covering’ the position. The stock trader now has to buy the shares at $23 and return them to the broker. The cost of buying the shares is $230,000 so they realise a loss of $30,000 excluding fees and charges. Short sellers also have to pay the lender of the stocks any dividends or rights that come due while they hold the position.
Stock traders also use short selling as a hedging technique. A trader may own shares in a company but believes they will decline in the short term. They do not wish to sell the shares because in their view it will only be a temporary decline. Instead, they can decide to hedge. By selling shares short they can profit while the market declines thereby off-setting the losses in the shares of their portfolio.
Short interest is a figure calculated by the exchange that reflects the total number of stocks or financial contracts outstanding. Some traders interpret higher short interest as a sign that the market is due for a decline but this is not necessarily the case. A market can continue to rise even under these conditions.
A short squeeze occurs when the market drives higher and short sellers exit their positions in large numbers. This adds extra buying pressure to the share price because the short sellers are rushing to cover their positions. Short selling often occurs when the market breaks through important resistance levels or rises to new highs. As the market breaks higher, short sellers fear they are in the wrong way and stand to lose a lot of money. Upward momentum increases as short sellers stampede to the exits.
Naked short selling is the illegal practice of short selling shares that have not actually being confirmed to exist for borrowing. This practice can force stock prices into a decline and interfere with normal market operations. During the financial crisis in 2008 many regulators banned short selling in an effort to stabilise the stock markets.
Going short is widely practised in futures trading as well. The seller of a futures contract hopes that futures prices will decline before the contract expires. Futures contracts require the trader to only put up part of the value of the contract to enter the position. Let’s say a futures trader sells one Dow Jones Futures contract at a level of 14000. Each one point movement in this contract is worth $10. If the market declines to 13900, the trader can exit the position by buying the futures contract back for a profit of $1000 (100 points x $10) excluding commissions.
Some commentators criticise short selling as the cause of major market downturns. Proponents of short selling maintain that it has an important economic function, adds liquidity, increases market efficiency and allows investors to expose securities that are overvalued. Short selling also acts as a support to share prices because they have to buy back the stocks at some stage and return them to the lender.
Regardless of traders views of short selling it is likely to remain an integral part of financial market operations and trading strategies in the future.
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