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Understanding Short Selling

18 Oct 2019
By
Short selling is a way to profit from falling stock prices. This can help diversify a portfolio but there are risks involved that investors should be aware of.

As it relates to the stock market, short selling, or shorting as it is commonly known, is a strategy employed when a trader or investor expects the share price of a stock to decline in the future. Being ‘short’ a security is the opposite of being ‘long’ which is the typical approach to stock market investing, whereby a stock is bought in anticipation of it rising in price.

More specifically, the act of shorting involves selling a parcel of shares that you don’t own, with the view of buying them back at a later date. Meaning, the trader still engages in a buy and a sell transaction, just in the opposite order of what one would normally do. In order to be able to sell the stock that is not owned; the trader needs to borrow it from someone who is willing to lend their stock to them. A common question is who lends their shares and why? Often, large institutions, will lend out a portion of their portfolio as they receive an interest fee from doing so, and thus can earn a little extra premium from their holdings.

While this process may sound complicated, CFDs have made the act of shorting much easier for retail clients, with a short position being just as simple to initiate as a typical long. More so, the whole process of sourcing the stock to borrow becomes the responsibility of the CFD provider, meaning it is not something that retail clients need to worry about themselves.

The risk of a short position is that the price of the stock rises, and the trader is forced to buy back the stock at a higher price, thus incurring a loss. When a stock is heavily short, what’s known as a short squeeze can occur, where a rise in the stock price forces more short sellers to buy back their positions, which only adds further demand for the shares, driving the price higher once more, which results in a feedback loop, which can push up prices very quickly. In theory, the risk of a short position is unlimited as there is no cap of how high a share price can go. This differs to a typical long position, where the maximum loss would be capped at the share price going to 0, or put another way, the investors initial position size. This makes risk management and the use of a stop loss very important when shorting.

Short selling allows for traders and investors to firstly make a directional trade, if they believe that a stock will fall in price, thus increasing the potential number of trading opportunities. However, short selling can also be used to hedge a position. Let say that an investor holds a stock, which for whatever reason they do not want to sell, an example being to avoid a capital gains tax event. If, however they believe that the share price could be at risk of weakness, they can open a short position in order to hedge their underlying stock position, and thus remove the price risk while the short position is open.

Short Selling – An example

A trader identifies a stock that they believe will fall in price over the coming weeks, which is currently trading a $2.30 a share. 10 days later they buy back the shares at $2.11.

  1. They borrow the stock and sell short 25,000 shares at $2.30, for a total sale consideration of $57,500
  2. In 10 days time, they buy back the 25,000 shares at $2.11, for a cost of $52,750
  3. The trader pockets the difference, being a profit of $4,750, not including brokerage and the cost to borrow.

In summary, short selling is a way to profit in the market when prices are falling. While our above discussion has focused on shorting stocks, traders can also open short positions in commodities, FX, and stock indices as well.

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