Many traders don’t understand the risks of short selling. This can cause them to lose their capital quickly, and this is further compounded by the fact that information can be conflicting.
This article will walk you through the art of short selling and answer many common questions related to shorting. Included are the main elements of short selling, such as the shorting definition, the costs of shorting shares, why brokers allow shorting the market, and much more in terms of strategies and what can be used to short sell the market.
What is shorting?
Short selling is the act of borrowing something you don’t own, selling it, then buying the stock back later date and returning it back to the lender. Short sellers bet that the stock they sell will fall in price so they can buy at a lower price and collect the difference as their profit.
For example, if I were to short Games Workshop, I would simply sell it. This requires the act of borrowing the stock elsewhere and selling it, with the goal to buy the stock back in future at a cheaper price.
A shorter speculates that the share price or stock value is going to reduce and to make a profit after returning the equivalent of the original stock to the lender.
Short sellers, therefore, profit from the difference between the selling price now and the price paid to buy the stock back.
Many assume that short selling is purely about stocks, but it can also be used in other markets, such as forex, commodities, for CFDs, and in spread-betting for instance. Most brokers offer a margin account to use derivatives such as CFDs and spread betting to trade short many instruments.
Shorting, or going short, works on the principle that we never own the stock we are trading. And so it appeals to many traders more so than going long on a stock, or longer-term investments, because of its associated tax benefits.
Why sell short?
Selling short takes place when a trader believes the value of the stock will fall and decrease.
For this reason, shorting is very rarely seen amongst investors, who work on the basis their investments will increase in value.
But it is a short-term profit strategy for experienced traders. When it works well, short selling is an opportunity for profit, without putting large amounts of money upfront.
In the case of hedge funds, shorting may be used for a percentage of the stock that would have been locked into a longer-term investment, to secure a profit or at least mitigate potential downside losses.
For example, if you are short an oil company and wanted to hedge your position, you may take a long position in oil.
In a stock market crash, shorts can be highly profitable. For example, in the Great Financial Crisis of 2008, Wall Street traders (and other traders!) who were short the housing market profited from this collapse.
How does short selling for a profit work?
To illustrate with an example, let’s say I borrow 10,000 shares of Vodafone plc stock at a stock price of 200p each, and sell them in the market. Once sold, I have a short position in Vodafone with exposure of £20,000. This means that I now have an obligation to buy 10,000 shares of Vodafone stock back in the future, in order to close my position.
Luckily for me, the price of the stock falls to 160p and so I decide to buy the stock back. The total cost for 10,000 shares at 160p is £16,000. Once the position is closed, I then pocket the £4,000 difference between the price sold for and the price I bought the stock back.
Here’s the calculation below.
Borrowed stock = 10,000 shares, sold @ 200p per share = £20,000 – £16,00 to buy 10,000 back @ 160p per share = £4,000 profit from the original sale.
However, this assumes that the trade went my way.
Sadly, not all trades work out like that and with shorting one needs to be aware of the risks.
What are the risks of short selling?
Many people believe that because you are selling something that you don’t own that your risk is infinite.
However, that is not always the case.
Thanks to the European Securities & Markets Authority (ESMA) in 2018, retail investors can no longer drop into negative equity. That means if you short an asset, the maximum that you can lose is the total funds in your account.
But that doesn’t mean it isn’t risky.
Short selling is an advanced strategy and not something new treaders should consider for use in their account or portfolio.
As a full-time trader, I use these shorting techniques to trade profitably. But shorting makes up a tiny percentage of my overall trades because going long is far more profitable than short selling.
However, in short selling, we must also be prepared to bear the brunt if things go the other way, and the share price increases before we’re able to close out our short position and buy back our stock. Checking market liquidity and depth is important.
And it does happen.
Why is this a problem?
Because a crucial element of short selling is the fact that the stock we sell is only ever ‘borrowed.’ We must return the same amount of stock to the lender, or broker, as part of the transaction (also see later ‘what are the costs of short selling?). Even the brokerage firm that offers the trade may have borrowed shares as collateral.
A fluctuating market can bring profits. But shorting can also present an infinite risk if the share price were to increase, resulting in short selling for a loss.
Example: Using that same stock I borrowed in XYZ Ltd from my broker, 100 shares, and sold to the open market for £10 each to make £1,000. In this scenario, the share price unexpectedly increases. I must return the 100 shares to my broker, so I decide that I should buy now, rather than wait for any further increase in share price. But this time, I have to buy back the shares I sold for £10 at their new price of £15 each.
Borrowed stock = 100 shares, sold @ £10 per share = £1,000 – £1,500 to buy back = £500 loss from the original sale.
The result is, I’m left £500 out of pocket, plus any incremental costs.
However, we cannot assume that we will be able to buy back our stock as and when we want to. Or for the price we want, as seen in the above example.
The market fluctuates, and it’s unlikely we will be the only players in the market with a short position.
If stock is not being sold, and there are too many short sellers also trying to close out their positions, we could be caught in a ‘short squeeze’ situation and incur further losses.
A short squeeze occurs when shorters are hurriedly closing their positions by buying back the stock and as a result the current market price of the stock with high short interest rockets. The price rises rapidly as the short sellers surge to close out their positions, buying back their stock and therefore increasing demand.
Buyers of the stock may also sniff a short squeeze and buy more stock! This then has a further detrimental impact for the short sellers of increasing the price even more. If a shorter is too much offside on the position, they’ll receive margin calls to either increase funds in their account or the broker will close the postion.
In such circumstances, the broker could demand that we cover the short, or return their stock, at any time. We may not have the luxury of holding out. This is a downside risk that long position holders don’t have.
What are the costs of short selling?
In addition to these losses though, the stock we borrow to trade doesn’t come free. Brokers take a risk lending stock, so will charge a commission, or a fee on their shares until the short position is closed out and their stock is returned.
Naturally, you’ll pay a commission to trade (unless you use a commission-free trading app which I don’t recommend) and so these costs are part of the total too.
So, why do brokers allow short selling?
As we’ve seen in the examples, short selling is a way to profit from falling stocks. But it can also go wrong, resulting in unanticipated heavy losses. It can be a risky business for traders.
Not so for the brokers though.
It is of no interest to them whether we lose or gain from the transaction. They are there to facilitate the trade, simply supplying the collateral with which we trade.
As already mentioned, they charge a fee and commission for their stock. In addition, interest on the loaned stock forms part of the broker account agreement, and in some cases, dividend payments will also be required.
At the very least then, they are guaranteed a form of financial ‘compensation’ as well as retrieving their original stock.
So, whilst brokers have an interest in short selling, their risks are minimal compared to risks for traders. But remember, if they can’t cover themselves, they’ll place restrictions on the stock for traders.
Is short selling ethical?
I am often asked why short selling is controversial.
Critics argue that short sellers who gain from a drop in the company’s share price have an incentive to see value destroyed for long-term investors. Taking advantage of a company facing a downturn could be viewed as unethical, and in the past, there have indeed been examples of such across the globe.
However, UK regulators hold a different view, with the opinion that if carried out as a genuine and transparent trading strategy, short selling alone does not lead to major market falls.
My view is that shorters are a necessary part of the market. If it wasn’t for shorters, there would be no incentive to call out frauds. German company Wirecard was shorted because it was a fraud – despite Commerzbank calling Financial Times journalist Dan McCrum fake news. Eventually, the fraud unravelled and Wirecard went to zero.
That said, like with anything shorting can easily be abused. Brokers can go short on a stock then offer a company money at a discounted price – they can then cover their short under the guise of ‘raising money’ for the company/
Trading short is more complex and riskier. Therefore, if short sellers want to take those risks, they should be allowed to participate in the rewards they earn.
UK short selling regulations
The Financial Conduct Authority (FCA) here in the UK is aware of the importance of short selling within effectively functioning markets.
Regulations are in place to ensure the FCA receives specific market data, in particular the “reporting of net short positions in relation to the issued share capital of a company that has shares admitted to trading on a trading venue” (The Short Selling (Notification Thresholds) Regulation 2021).
The private notification threshold will reduce from the current 0.2% down to 0.1% on 1st February 2022. Public notification is required from 0.5% and for each 0.1% of the issued share capital above that level. The FCA website hosts public disclosures.
Some other regulators have at times placed a ban on short selling, and there was an outcry from Reddit’s WallStreetBets when many brokers stopped taking trades on Gamestop. However, this was due to the extra margin demanded by the broker’s prime brokers.
What is shorting in summary?
To summarise, short selling is the borrowing of stock to sell on the open market with a view to buying back at a later date, at a profit.
I believe novice traders or unprofitable traders should avoid short selling, but shorting is a great way to rack up quick profits on a falling stock or profit from a stock you believe is a fraud. Remember the upside on a short is only ever 100%, whereas going long the upside can be unlimited.
If you have any queries and are looking for further guidance and support, please access my short selling guide for more information.