Q:What is ‘naked’ short-selling?
What are the dangers of shorting a stock? A: When going short of a stock you are effectively selling something you don’t own. In order to do this you have to borrow the aforementioned stock and then sell it in the market. The objective is that when the price falls, you then buy back from the market and return the stock to whoever you borrowed from, paying a borrowing cost into the bargain.
There are various associated dangers, e.g. the lender of the stock can ask for it back at any time, including at a point when you are making a massive loss. Your broker can’t sell what they don’t have so you would have to return the stock (unless you wish to default, which is not a good idea). This is known as ‘being called away’, and although it does not happen frequently it is possible if a lot of traders are short-selling a particular security.
Similarly, if a dividend is paid against the stock whilst in your possession, you are responsible for paying that dividend to the stock lender. Likewise, if the stock splits during the course of your short, you’ll owe twice the number of shares at half the price.
Q:What is ‘naked’ short-selling?
Why is selling a share anymore risky than buying one? A: A few reasons:
- Buying a share exposes you to limited risk (you can lose up to 100% of your initial investment) and unlimited gain (share price can go to the moon, e.g. takeover bid or other disruptive announcement). This is reversed with shorting – limited gain (100% of your initial position, unlimited risk).
- Shorting requires someone, on your behalf, to borrow a share so that they can sell it. This share can be recalled at any time, if the original holder wants to sell it. At times of high market volatility, you may be required to cover your position by buying the shares back (this may be done automatically, by closing a spread bet or CFD).
- Stock markets tend to rise over time, and at any rate, shares tend to pay dividends. If you are short, the tendency for inflation to push up share prices works against you, similarly, the dividend has to paid out of your pocket.
- A sharp rally in a particular share can trigger a large number of short sellers to cover their positions all at the same time. This can push the stock price even higher, causing ever more short sellers to cover their positions, and so on. In such circumstances, the stock is said to have been caught in a ‘shorting squeeze’. Volatile shares with large short interest are particularly susceptible to this phenomenon, so prospective short sellers should be wary of shorting shares that are already being heavily shorted.
- Short selling, or financial instruments that perform a similar function (put warrants, spread bets, CFDs and futures) tend to be leveraged instruments, or margin traded. e.g. a £1000 deposit to a spread betting account, may allow you to place bets equivalent to short selling £10k of shares. Although this is not an inherent risk, an appropriate risk management strategy (e.g. calculating the total exposure before placing the order) is required to ensure you don’t take an excessive position. This is a common mistake among novice CFD Traders and spread betters- e.g. a ‘£10’ spread bet on the price of gold sounds innocuous enough, until you realise that the amount of gold you are actually trading is worth as much as a house.
Also, some instruments with an inverse return (e.g. put warrants) or ‘constant-leverage’ inverse funds don’t necessarily show the same returns as shorting directly. E.g. put warrants have a value with a complex relation to strike price, time value and demand/supply as well as the underlying share. Similarly, constant leverage funds adjust their inherent value on a daily basis (so although the return on a daily basis is inverse, the long term value may not follow the inverse) as well as showing supply/demand fluctuations during the course of a trading day.
‘Short selling is risky and should only be attempted by experienced traders. There is, in theory, no limit to how high a market can go – and if a market rises when you are short, you lose. If the short-seller gets it wrong, it can really hurt. That said, great fortunes have been made on the short side.’ – MoneyWeek