The Investors Guide to Short Selling

What is Short Selling?

Short selling in the financial markets means borrowing an asset such as a stock from a broker to sell them at a high price, and then buying them back when prices have fallen so as to return the asset to the broker, and benefiting from the price differentials.

Short selling is used when there is an expectation that the price of an asset will fall within a space of time. Traders generally carry out short selling to make money from falling prices or they use it as a hedging strategy to protect themselves from fall in prices on assets in which they have long positions.

Short Selling as a Hedging Strategy

For instance, a trader may be long on an imaginary stock we shall call XYS, and he may then decide to short sell the stock options on XYS. The strategy is played in such a way that if XYS has a bullish run if the trader is long on it, and the short sale option is out of the money as a result, then the cost of the short sale loss will be far less than the outcome of the long trade on the stock. But if the price of XYS drops and puts the long position in a losing position, then the gains to be made from the short sale will far outstrip the loss on the long position on XYS. In this scenario, short selling XYS will act as a hedge trade.

Short Selling in a Falling Market

Traders can decide to employ short selling as a strategy to gain from falling prices, especially when the fall in prices is a systemic problem and not restricted to a sector or a single stock. This is why in the weeks following the collapse of Bear Stearns and preceding the collapse of Lehman Brothers in 2008 (the events that triggered the global financial crisis), traders massively engaged in short selling of stocks, especially those of the financial sector because they were all in a predicable free fall.

However, there is a very thin line to tread when trading a systemic fall in prices, because it gives room for spreading of negative rumours and when everyone is selling, it tilts the equilibrium of the markets. Regulators will always step in when this occurs, and we have seen bans on naked short selling at various times when there is systemic crisis. So if a trader wants to short sell as a profit strategy, then the best bet is to identify individual or sectorial assets based on technical and fundamental analysis, and short sell those assets with a bearish outlook.

Conditions for Profiting from Short Selling

Short selling is an extremely risky strategy. If you are familiar with the collapse of MF Global, a financial services company that short sold the Euro in expectation of a fall in the value of the single currency in a massive bet that went horribly wrong, then you can imagine how risky the strategy is. A trader can lose a lot of money in an instant.

For a trader to be able to profit from short selling, the following parameters must be met:

1)    The trader must be able to locate an asset to use for short selling. To do this, the trader must have a trading account that provides enough margin for short selling, and also permits short selling.

2)    There must be enough liquidity in the asset to enable the short seller get buyers of the asset at the market price.

3)    The price of the asset in question must experience a price drop to put the trade in a profit.

4)    The trader has to be able to buy them back at a lower price.

5)    The asset in question must not be one restricted from short selling by the regulatory authorities.

Advantages of Short Selling

Short selling is a very good way to trade a bearish expectation for an asset. There are many emerging market exchanges that only permit stock purchases, and traders can only make money from bullish runs. Trading in these markets can be frustrating because opportunities to make money are restricted. But with short selling, a trader’s opportunities to make money even from falling assets are limitless.

A good example of a profitable short sale was that performed by George Soros’s Quantum Hedge fund which made more than $1billion in profit by short selling the British Pound in September 1992. Another trader who made money shorting a market is doctor-turned-investor Michael Burry, who made more than $600 million from short selling the credit default swap instruments on the US subprime housing market. Economists like Nouriel “Dr Doom” Roubini have regularly predicted periods of market crashes (he predicted the housing market bubble in 2005, long before prices began to tank), and such analyses easily form the basis for making huge profits from falling markets.

Short selling is also very useful for hedging and protecting profits. As was illustrated earlier in this article, short selling is a tool that allows traders to make up any losses incurred on the asset from unprofitable long positions. Many hedge funds who were long on stocks and stock markets used shorts to cover these positions and were able to use it to come out relatively unscathed when the cards came crashing in 2008.

How A Trader Can Make Money from Short Selling

A good target for a short sale would be an asset which is heavily overbought and whose fundamentals are not in tandem with its high prices. A good example of this was seen in an emerging market in Africa, where the breweries subsector was experiencing a massive price boom. There were questions over the state of health of some of the breweries whose stock prices were enjoying this sectorial boom, and a concerned investor decided to visit one of such breweries. He met overgrown weeds, a non-functional plant, a few workers and dilapidated structures. With this information, he quietly exited his holdings and within a short time, the information came out and the stock tanked. Such fundamental analysis is what is used to make informed decisions on what asset to short sell.

There are also technical indicators to consider. Is the asset forming a top or a bottom? There are several ways of identifying tops, bottoms, continuations and reversals on the charts. These can be used as a basis for short sale. A short seller would be looking to sell a market top or a bearish reversal pattern.

Issues Regarding Short Selling

The market bias of traders is partly influenced by market news, some of which are facts and some of which are rumours. Nothing causes market panic more than negative rumours. Part of what fuelled the systemic collapse of global stock markets in 2008 was fake market rumours following the collapse of Lehman Brothers. Many traders would enter short selling positions in certain assets, then float negative rumours to force the asset price to tank so as to profit from these moves. From there on, it was a season of short selling which served to collapse the market further. You can get an idea of how this works from the film Casino Royale, where the villain of the movie tried a terrorist attack on a new-design aircraft hoping to profit from the collapse of the airline’s shares (which never happened thanks to 007).

This and other unethical practices led to a ban on naked short selling by many regulatory bodies across the world. Today, several degrees of restrictions on short selling are still in place. So if you want to practice short selling, you need to be conversant with the rules in your jurisdiction so as not to run foul of the law.

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