Many people have heard of short selling thanks to the 2015 Hollywood movie The Big Short by Adam McKay, based on the book of the same name by Michael Lewis. Others may have heard of the practice after the GameStop short squeeze in 2021, which saw users of the investment app Robinhood buying shares in a failing company to prevent hedge funds from profiting off its decline.
Neither instance gave short selling a particularly good name, and many people have come to see the practice as an example of the poor ethics involved in market trading. However, most economists and financial experts are agreed that short selling is an important part of maintaining a healthy and efficient market.
So what exactly is short selling? How is it done? Who does it? And is it as unethical as some people make out?
We will explore all this and more as we jump into: a beginner’s guide to short selling.
What is short selling?
Short selling is a trading strategy that involves speculating on the fall in the value of a particular stock price, selling that stock, and then buying it back at a lower price. Short selling is an advanced trading process that can be very high risk and is, therefore, only suitable for experienced traders.
To engage in short selling, you must have a margin account. Margin accounts are usually only available for traders with a certain amount of cash or securities, so short selling is generally only practised by hedge funds and advanced speculators.
How does short selling work?
Short selling is best illustrated by using an example. So, let’s say there is an investor or speculator who wants to short sell stock for a car company called Premium Motors.
- By analysing the market, the investor speculates that the value of Premium Motors is going to fall over the next few months.
- The investor approaches a broker-dealer and asks to borrow shares in Premium Motors. Broker-dealers can loan out shares that must be returned to them within a given period plus interest.
- The broker-dealer agrees to lend shares to the investor as long as the investor returns the shares plus an additional fee of £100 – the interest can be any figure, but £100 allows for simple mathematics.
- The investor then sells the shares they have borrowed from the broker to the market for £500. This is known as opening a short position.
- The investor then waits for the value of Premium Motors stock to fall, which they already speculated would happen.
- When Premium Motor’s value falls, the investor buys the shares back from the market for £200.
- The investor then returns the shares to the broker-dealer plus the £100 of interest they promised.
- So, the investor has: sold the borrowed shares for £500; bought them back for £200; and then paid the broker-dealer £100.
- This means that the investor has made £200 overall by correctly speculating that the stock value of a company will fall.
Why do people short sell?
The simple reason most investors and speculators short sell is to make more money.
With short selling, a speculator is essentially making a bet that the stock of a certain company will fall in the future. As with any bet, they may be wrong, and if they are, they will have to buy back the shares at a higher price plus the interest they owe the broker. This is why only highly experienced traders and speculators should engage in short selling.
Hedge fund companies use short selling to offset potential losses in riskier investments. This process is called “hedging,” hence why the companies that do it are known as hedge funds.
How do you measure short selling?
Investors and speculators need to understand how much short selling takes place in a market to make more accurate predictions on which way it will turn.
Two metrics are used to measure the amount of short selling in the market. They are:
- The short interest ratio (SIR). Sometimes known as the short float, the SIR measures the number of shares that are currently shorted against the number of shares available in the market.
- The short interest to volume ratio. Sometimes known as the days to cover ratio, this metric measures the total shares sold short divided by the average daily trading volume of the stock.
Is short selling legal?
Short selling is legal and an important part of the trading market.
Although it is seen as an unethical practice by some, as the speculator profits from company failures, it is understood as an integral component of an efficient market.
What are the advantages and disadvantages of short selling?
As with any bet, short selling has both huge advantages and disadvantages.
Short selling can return huge profits from very little capital. But on the other hand, short selling can be risky and cost the speculator a lot if they are wrong about the fall in the price of the stock.
The risk is heightened because the speculator must return the borrowed shared to the broker. If the share price rises instead of falls, the speculator must still buy back the shares to return them to the broker. The rise of the share price can potentially be unlimited, so the speculator can lose huge amounts of money.
Short selling can also be an efficient way of hedging other investments. But there is always the risk that other traders are shorting the stock, which means it may be hard to buy them back. When this happens, it can result in a “short squeeze,” which is when the value of the stock starts rising as so many speculators are trying to short it at once.
Advantages of short selling:
- There is a good possibility of high profits if the trader is experienced.
- Very little capital is required.
- It can be used to hedge against other riskier holdings.
Disadvantages of short selling:
- If the stock rises rather than falls, there are potentially unlimited losses.
- You must have a margin account to borrow from a broker, which usually requires you to have a certain amount of money or securities. So not everyone can engage in short selling.
- If too many speculators try and short a stock, it can result in short squeezes, which leads to the price of the stock rising again.
When should you short sell?
Short selling is all about timing. Stocks normally fall in value at a much faster rate than they advance. This means that the short seller has to perfectly time their trade to maximise profits.
If a speculator sells their shares too late, the stock may have already fallen in value, which means the speculator has already lost some of their potential profits.
However, if a speculator enters the trade and sells their shares too early, they may find that they have misjudged the fall in the stock’s value and end up buying the shares back at a higher cost.
Here, we will look at some instances when it can be a good idea to start short selling.
When there are high valuations due to optimism
Certain industries and markets can reach very high valuations when there is a lot of optimism surrounding the prospects of such industries or in the wider economy as a whole.
However, experienced speculators know that such periods do not always last and that, even if the industry does have good long-term prospects, the rampant optimism will cause the value to inflate. This means that the value will eventually fall, so selling shares to the market while the prices are high might be a good idea.
During a bear market
A bear market is when a market experiences a prolonged price decline. This can happen during a financial crash, a war, a global health emergency, or other big events that lead to instability and unconfidence in the market. The opposite of a bear market is a bull market, which is when prices are rising.
During bear markets, speculators can make a lot of money by selling shorts as the whole market is in steady decline.
Many critics of short selling highlight bear markets as a particularly contemptible practice because traders are making profits off the financial instability of others.
When stock fundamentals deteriorate
Stock fundamentals are all the factors that contribute to the overall value of a company.
Stock fundamentals can deteriorate for all manner of reasons that may be specific to a certain business or sector – such as rising costs of production, a fall in demand for certain goods, etc. – or may be due to wider issues that are not directly related the business – such as war, economic instability, natural disasters, etc.
An experienced short seller should be able to notice the difference between the natural fluctuations in a sector and the deterioration of stock fundamentals. The ones who make the right predictions or observe the downward trend early can cash in and make large profits by short selling the stocks they see are on the decline.
Is short selling ethical?
For many people, short selling and short sellers are indicative of the Wild-West culture in market trading. The idea that wealthy investors can make profits when companies, sectors, or even whole economies fail is, in their eyes, highly unethical.
Short selling gets a bad reputation thanks to practices of unethical speculators who often artificially manipulate markets to force the value down of a stock they have shorted. While there are regulations to try and keep this in check, they do not always work, but that does not mean that short selling is entirely unethical as a whole.
Short selling provides liquidity, which means that real money is kept in the market rather than just speculative pricing. This means that the market is kept more efficient and does not continue to inflate and rise due to hype and optimism.
Short selling stocks can be done for manipulative and unethical purposes, but just because bad faith actors can use the practice does not mean it is inherently unethical. A healthy market relies on short selling to keep it liquid and ensure it does not rise too rapidly during times of relative confidence.
Summary
Short selling refers to the practice of betting on a fall in a stock’s price by borrowing shares, selling the shares, and then buying them back. Although short selling can be highly profitable, it can also lead to potentially huge losses. For this reason, it is not recommended that you attempt to short sell unless you are a highly experienced speculator.
Short selling has a bad reputation thanks to the unethical practices of some speculators. However, it is widely acknowledged to be part and parcel of a healthy market. If you want to benefit from short selling but have no experience, it is best to approach a hedge fund that can assign you a trader to do it on your behalf.