Short Selling: Myths and Facts
Short-selling has been in the news recently, and short-sellers have been blamed – perhaps unjustly – for a great deal of damage and some banks being forced into mergers or receivership.
Short positions, based on properly borrowed stock where the holder gets a good return from lending, correct and prompt delivery, and sensible margin levels certainly has a place in the system
Q:What is Short-Selling?A: Whilst the stock markets tend to rise over time, there are often short periods of turmoil when individual stocks, currencies or stock markets as a whole, decline in value. For instance, the tech-bubble burst in 2000, Sterling’s collapse from €1.52 and $2.11 in 2007 and the more recent October 2008 credit crunch induced Dow Jones collapse, started by the banking sector. Buy and hold investing aims at profiting from a rising asset price (also known as ‘going long’) and then selling when you believe the stock price to be overvalued. You would then for the stock price to fall back to present you with another buying opportunity. In the past, it has been difficult for retail investors who have perceived a weakness in a market, or company, to take advantage of the anticipated fall.
Short Selling Defined
Have you ever been absolutely sure that a stock was going to decline and wanted to profit from its unfortunate demise? And wouldn’t it be nice to see your portfolio increase in value during a bear market? Well, short selling empowers you to do so!
The method of profiting from a falling share price or market is known as ‘shorting’, ‘going short’ or ‘short selling’. Short selling is a trading strategy allowing you to make money on a decline in a financial instrument. Selling short is basically opening a position with a sale rather than with a purchase (going long). Short-selling is when an investor believes that the price of an asset, such as stocks, currencies oil or gold contracts, is going to fall, and agrees to sell that asset in the relevant market at a certain price – without having actually purchased the asset. The arrangement will need another party, who believes that the price of the asset is going to rise, to purchase the shares or currency. Although this may sound counter-intuitive, in reality shorting is just the opposite of investing in a market that is expected to rise.
So short selling involves selling shares that, essentially, you do not own. This is when a trader borrows shares from a broker and sells them, hoping the share price will fall. They buy the shares back at a lower price before they have to be returned, crystallising a profit. Brokers charge a fee for lending out the shares. There are two types of short selling: naked and covered. Covered selling being the more common approach involves borrowing the shares from someone who already owns the shares as we have already seen above.
There are two situations; covered, where you own the shares already and naked or uncovered, where you do not own the shares already (much more risky).
I think shorting is a good thing for traders and investors to have at their disposal – to be able to make up their own minds whether a stock should go up or to go down, and to be able to act on that belief, either long or short, with equal efficiency. There’s no reason why stocks have to go up. If a company is underperforming, its share price should not go up nor stay the same, it should go down. 25 years ago, it was very difficult to act on the idea of a stock going down. Nowadays with a CFD it’s simple.
Q:I still can’t understand what short selling is…
Do I just type in a number of shares under sell 100 GOOG at $343. I just don’t get is that how you do it? Then when you want to sell it back at a lower price how do you do it?A: Imagine being able to sell something you do not own and being able to buy it back at a cheaper price sometime in the future. Just think if you could sell your car to your neighbour for $6000 while you were overseas for 4 months and then being able to buy it back off him when you returned for $5000. A cool $1000 gain and you still retain the car! This is essentially short selling and shorting using CFDs is now a widely used technique to profit from a falling market.
Think of short selling in this way: If you buy something and then you sell it you realise a gain if you sell it for more than you paid for it and a loss if you sell it for less than you paid for it. If you sell something and then you buy it back you realise a gain if you buy it back for less than you sold it for and you realize a loss if you buy it back for more than you sold it for. The idea that you first sell something and then you ‘sell it back’ doesn’t work.
To Summarise -:
- When shorting a trader borrows the shares and sells them. He will then have to return the stock at some point in the future (cover). A gain or loss is made on the difference between the price at which the shares were borrowed compared to the price at which they are given back.
- An investor will gain only if the shorted company’s stock price falls.
- Short selling is made on margin and thus follows the rules of margin trading.
- A trader with open short positions has to pay the lender any dividends or rights given during the holding period.
- Short selling is mainly used for speculation and hedging purposes.
- It is quite straightforward to short commodities and indices. To be able to short a share your broker will need to find a holder willing to lend you the shares; this implies that shorting individual shares may not always be possible (this applies especially to the smaller companies which might have insufficient liquidity).
- You can gain an insight into the percentage of a particular stock on loan by checking the short interest and crest loan data.
- Shorting is risky. The potential gains are limited (since a share can’t go down less than zero) but the potential downside can be unlimited (as theoretically there is no limit as to how high a stock can go, however in practice shorters can control their exposure using stop loss orders). Moreover, normal trends for markets are on the upside so you have to be very disciplined with regards to risk management.
- A short squeeze can happen if a significant percentage of a company is currently being shorted. This happens when a large number of shorters try to close their positions at the same time which pushes up the share price.
- A stock price can continue rising for a long time (even if overvalued) before correcting. Fighting a trend can turn out to be an expensive exercise. It is safer to sell short during bear markets rather than when everyone seems on a buying spree.
- Prices tend to fall much faster than they rise. This is good news for day traders as the shorter the holding period, the less risk you are exposed to.
- Some investors look down on short selling and consider it evil and unethical.
- Shorting makes the market more efficient by providing additional liquidity and adds a voice of reason in roaring bull markets.
- A few unethical traders might try spreading false rumors and information to try driving the share in the direction that suits them.
- Beware of shorting stocks when the wider market is experiencing upward momentum as this increases the shorting risks since even poor companies can perform ok in a persistent bull run (bargain hunters tend to look around for stocks that have yet to rally).
It is often said that stocks take the stairs on the way up…and the elevator on the way down. This is true – stocks tend to fall 3 times as fast as they rise as panic takes hold of investors.
Q:Can you show me an example where you short-sell a stock?A: ‘Going Short’ simply means opening of a short ‘sell’ CFD trading position to profit from a fall in prices.
Short CFD Trading Example: You saw that Game Group (LON:GMG) had breached a key support level and looked set for a pullback. You place a sell order for 40,000 GMG shares at the prevailing market price of 145p. The market value of the trade is $58,000 [1.45 x 40,000] and the margin rate on GMG is set at 15%. Thus, $8700 is required as Initial Margin collateral to open the trade. The trade is placed and you hold a short GMG CFD position with a market value of $58,000.
GMG issues a profit warning and in the next few days the price drops to 116p. Assuming that the position is closed at this price, the trading profit will be $11,600, which represents an excellent 133% return on investment.
However if the trade had gone against your position and you had decided to close the position when GMG was trading at 160p, you would have lost $6000.
Note that when opening a short position you receive a cash payment for the full market value of your short position and therefore receive interest on this amount at the LIBOR target rate minus 2.5% per annum (note: no daily interest is paid at the present time as interest rates are so low). The overnight interest rate is computed by dividing the per annum applicable interest rate payable by 365 (days per year).
Q:Tell me about the history of shortingA: Whilst short selling may have its roots much earlier, in its present form short selling has existed for around 400 years. The practice of short selling supposedly has its origin in the 17th century when a Dutch merchant named Isaac Le Maire invested 85,000 guilders in the Vereenigde Oostindische Compagnie becoming the largest shareholder in the process. Isaac never received any dividends and the ships were actually under constant threat in the Baltic from the English. Soon he fell into conflict with the VOC and he decided to sell his securities in the company. Further to this he founded a secret company with the purpose to trade in VOC shares. In fact, he was so convinced of Vereenigde Oostindische Compagnie’s calamitous position, he ended up selling more securities than he had ever actually owned.
The earlier famous examples of short selling have typically presaged the end game of all the famous bubbles in the past few hundred years. These include the Dutch Tulip Mania of 1637 – 1638, the South Sea Bubble of 1773, and the Wall Street Crash of 1929. In fact, the first ban on shorting was by the Dutch in 1610 on the grounds that selling something you did not own was rather like bouncing a cheque. The next ban was in the UK in 1787 to protect banking stocks after a banking collapse. Perhaps the common link between previous down cycle is that bans tend to mark the beginning of the end of a down cycle, rather than the worst part.