short selling

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If you enjoy movies, then the 2015 film “The Big Short” directed by Adam McKay and starring Christian Bale as hedge fund manager Michael Burry provides an enthralling study of both the advantages and disadvantages of short selling.

In the movie, Burry bets over $1 billion against mortgage-backed securities, essentially short selling the US housing market, for which he must pay high monthly premiums. When the market collapses and triggers the 2007-2008 financial collapse, he makes a $2.69 billion profit.

Short selling has also been the subject of controversy in more recent times with stocks like Gamestop and the app Robinhood causing a media frenzy after stocks which were heavily shorted by hedge funds were bought en masse by retail investors, sparking off a “David v Goliath” battle.

The market turmoil which ensued alerted the attention of Congress and led to a great deal of debate about the role of short selling on the stock market. Questions were raised again about whether short selling should be more heavily regulated – or even allowed at all.

Here though we take a look at the potential advantages of short selling and also some of the pitfalls from the point of view of everyday traders like you and me.

What is Short Selling?

Short selling is making a bet that the price of a stock or other security will fall. The mechanism is simple. You borrow the security and sell it. You wait for the price to drop and once it has you buy it back so you can return it to the lender. You profit from the difference between the two prices.

Looking at it in a little more detail – to open a short-selling position, you borrow shares of a stock or other asset that you believe will decrease in value by a specified future date, known as the expiration date. You then sell the shares you borrowed to a buyer or buyers who are willing to pay the market price.

You are betting that the price of the asset will fall before you are obliged to return them. If the price does fall, you can buy them back at a lower price than you sold them for. To close the position, you return the shares to the lender.

As you have borrowed the shares, you will have to pay interest on the borrowed shares until you return them – in other words, until you close the position. Before you can do any of this, you need to have a margin account with your broker. As you have borrowed the security, you will need to pay interest on the loan, which is the price at the time you borrow it.

Of course, a problem arises if, rather than the price falling, it rises. Should that be the case, you have two choices. Take the loss by closing your position, or wait and hope the price does fall – incurring more interest and potentially more losses if it doesn’t.

In CFD/spread betting terms short selling is even simpler – you are effectively just betting that a particular instrument will drop in price by selecting “sell” on a trade. For every pip it drops in price you are making a bigger profit and for every pip it increases in price you are making a bigger loss – until you close your position.

Advantages of Short Selling

Large institutions like hedge funds are famed for their shorting tactics and for making billions in profit from the practice, but there also can be some advantages to short selling for the retail investor.

Whilst statistics show that most amateur traders tend to shy away from short selling and prefer to buy – or “go long” in trading parlance – short selling can actually be advantageous for both short-term trading and long-term hedging, as we will see below.

The advantages of short selling include:-

Using knowledge to benefit from trends and cycles

In its most simple form, the ability to sell short allows traders to benefit from their knowledge and research on stocks and sectors that show signs of being in decline.

In recent times that might have been traditional retail which has been swamped by e-commerce, the mobile phone industry and companies like Nokia and Blackberry being disrupted by the advent of the smartphone, or the DVD sector and companies like Blockbuster being disrupted by Netflix and other streaming services.

If people can see that significant changes in the economy are happening due to disruptive technology, behavioral change, cyclical factors or for any other reason, then by shorting a stock or sector they have the chance to be proved right about their prediction and make a profit.

As financial instruments have always tended to fluctuate in price over time, the ability to go short allows traders to take a position on the sell side and not just the buy side of a trade, thus potentially benefiting from both sides of price fluctuations.

Check out top trading systems that have passed live trials on our site here.

Benefiting from hype

One particular method traders may use to short sell is to take on stocks that have been over-hyped and lost touch with reality and the basic fundamentals.

For example, a few years ago the stock price of Nintendo soared after the release of popular game Pokemon-Go, as casual investors presumed the excitement about the game would translate into profits for the Japenese console and video-game manufacturer.

However, after their stock price soared Nintendo came out with a statement clarifying that contrary to popular belief they were not in fact the manufacturer of Pokemon-Go and only had a small financial interest in sales of the game.

After this statement the stock fell back down to approximately the level it was before the episode. Those traders who took the time to research the correct situation around Pokemon Go could have profited from this by selling the stock at the peak of the hype.

A similar situation occurred in 2021 when a group of users known as “wallstreetbets” on social media site Reddit went long on the stocks of struggling companies like Gamestop, AMC and Blackberry.

Those stocks then experienced steep rises, with Gamestop in particular soaring to astronomical levels that were totally out of touch with traditional fundamentals like revenue and profit.

At the peak of the hype, Gamestop’s stock rose to $347, from just $17 at the start of the year. Nothing had fundamentally changed about the company or its fortunes in that time; the rise was purely sentiment driven.

Inevitably, reality caught up with the situation and the stock fell back towards previous levels, hitting $40 in February.

Whilst the dynamic around Gamestop and these other “Reddit stocks” was complex and part of the story was the battle between the “little guy” (or retail trader) and the Wall Street hedge funds – a “David v Goliath” narrative – it is important to remember that at the peak of the frenzy around these stocks they were wildly over-valued on traditional metrics and had a significant risk of falling in price once the hype died down and investors took a cold hard look at their underlying value. Some traders saw this and were prepared to short the stocks at the height of the craze.

So we can see that knowledgeable and smart traders can benefit from short selling in situations like those involving Nintendo and Gamestop.

Using short selling as a hedge

Some traders on the other hand like to use short selling as a hedge against other positions they have open.

For example, a trader might have a number of stocks in gold mining companies and feel that whilst those companies are good investments in themselves, they could suffer badly from a drop in the price of gold.

So as a hedge against these positions they could short gold, not to a level that could wipe out their gains but just to provide some degree of protection against a factor that could drag down the stocks’ prices.

There are various instruments nowadays that allow people to short the stock market in general, whether that is the S&P 500, Dow Jones, FTSE 100, DAX or indeed many other indices around the world. Shorting an index can provide some downside protection to those with portfolios in stocks that could be negatively affected by a market crash.

With the advent of the internet there are now a whole host of other financial instruments available for traders to hedge risk, including the “fear index,” or VIX, currency baskets, index trackers and much more besides.

Selling these instruments short can provide investors with a degree of protection if used correctly, although the advice of a financial advisor would be recommended for this, and any other form of investment of course.

Providing a check and balance to over-exuberance

Just as there can be hype around individual stocks, so there can be over-exuberance around the market in general, when prices start to lose touch with reality.

Short selling can provide a check and balance on this, ensuring there is not a runaway bull run that gets completely out of hand. There will be some traders willing to look beyond sensational headlines to the underlying fundamentals and bring a sense of reality back to the market by selling short.

It is this back and forth, yin and yang, that keeps things in check and stops bull runs becoming snowballs that get out of control.

That is not to say that bull runs followed by crashes don’t still happen of course, but short selling provides a tool to keep a leash on the market to prevent it from getting too far ahead of itself.

Profiting from the “short squeeze”

This might not necessarily be an advantage for short sellers themselves, but an interesting dynamic that sometimes plays out is that short selling can occasionally – and perversely – actually help a stock and those who hold it.

This can happen when a stock is heavily shorted but then starts to rise significantly. Short sellers are forced to cover their position by borrowing more stock – or closing their position, forcing the stock up higher. This is called a “short squeeze.”

An example of this dynamic played out with Tesla, which in 2018-19 was one of the most shorted companies on the stock market. For a while, the high amount of short selling acted like a brake on the stock, preventing it from going higher.

However, after Tesla started producing a regular quarterly profit in 2020 and showed resilience in the face of the coronavirus panedmic, the stock started to rise substantially.

As it did so, some short sellers were forced to cover their positions – others may even have shorted more at higher prices. The stock price continued to rise however, more than trebling between the March lows of the pandemic and July.

As some short sellers were forced to close out their positions, the “brake” on the stock was effectively removed and the stock continued to soar. Those short sellers who had shorted again were then in an even worse position and had to either close their positions for a huge loss or take an even greater risk by shorting at ever higher prices.

Eventually most of the shorts were forced out as Tesla’s stock ended the year up over 800% from its March lows. Some shorts made eye-watering losses and vowed to leave the stock alone in future, effectively admitting defeat.

Tesla CEO Elon Musk taunted the short sellers on Twitter and even had a limited edition of Tesla shorts produced which he called “short shorts.”

Whilst it is impossible to calculate with any degree of accuracy exactly how much of a role the “short squeeze” had on the stock’s rise, it is likely to have played at least some role in Tesla’s meteoric growth in 2020. In that sense, whilst the short sellers initially acted as brake on the stock, they ended up potentially helping those who held the stock.

Unlimited potential loss?

As this story attests, there are considerable risks with short selling and it is not for the faint-hearted. The danger with short selling is you open yourself up to an unpredictable and potentially high loss. As you have borrowed the shares on margin, you must continue to pay interest as long as the position is open.

Should the margin increase too much, your broker might issue a margin call, forcing you to repay some of the loan.

If you fail to do so, your broker is likely to close out the position leaving you with a loss. But even if you can refinance your margin, you will still be losing interest on the margin, and if the price fails to fall below its value when you bought the stock, you will eventually have to close the position.

Unlike a long position, in which the most you can lose is your initial investment, with short selling there is no way of knowing how much you could lose – although you can use stop losses to limit your liabilities if trading CFDs or spread betting.

Not knowing how much a stock may rise has been a particular issue for those short selling high growth stocks in the tech sector, which over the last couple of decades have shown a propensity for growing faster than their underlying fundamentals would suggest, or have simply grown far beyond what most would have predicted.

Who would have thought, for example, that a company that started out life as an online bookstore and had a stock price of around $3 in the early years of this century would grow into the behemoth that is Amazon with a stock price of over $3,000 by 2020 and providing web services, movie streaming, a huge logistics network and producing its own products.

Or a company that started out as a mail-order DVD service with a stock price of $1 would one day grow into the online streaming superstar of Netflix with a stock price of over $500.

You would certainly not have wanted to be shorting these stocks at $1 and $3 and have had to watch their huge growth over the ensuing years.

Of course, most traders would have been forced to exit long before the astronomic gains were seen, but the lesson is that some stocks can grow by unimaginable amounts and be very painful for short sellers. Using stop losses is strongly advised if shorting stocks to limit the risk of an exploding stock.

Whilst there is all this risk on the downside, it is worth remembering that your maximum gain when shorting is limited to the price of the security when you bought it. If you shorted $1,000 worth of stock for example, and its price fell to zero, your maximum profit would be that move from $1,000 to $0, minus the interest you paid on the margin. The stock cannot go below zero, whereas it can grow by an unimaginable amount.

Is it Worth the Risk?

If you know what you are doing, then, as part of a carefully planned strategy, short selling can have its advantages.

But it shouldn’t be a strategy for the inexperienced trader and does come with substantial risks, so if engaging in short selling it is normally a good idea to limit your risk and use stop losses and other risk-reduction strategies.

Whether going long or short, you can always benefit from a good trading strategy. Check out our list of systems that have passed a live trial on our site here.

 

 

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