The mysteries of short selling

You can use numerous different tactics when investing, including technical analysis, momentum, and many more. However, one tactic is often misunderstood and sometimes described as immoral and unethical – short selling.

 

What is short selling?

 

In simple terms, short selling is the action of selling a stock that you don’t own with the idea of buying back at a lower price, crystallising a profit. This prompts many questions, which we will cover:-

 

Why would you short sell a stock?

 

If you believe a stock is overvalued and likely to fall, this is the perfect scenario for a short sale. For example, if Company A was priced at £10 a share and you believed that, compared to competitors, the real value should be nearer £8, you could carry out the following transactions:-

 

Sell 10,000 shares at £10 = £10,000 proceeds

 

The price then falls to £8 a share:-

 

Buy 10,000 shares at £8 = £8,000 cost

 

Profit = £2,000

 

In reality, you would need to consider commission and other charges on the sale and purchase.

 

How do you sell shares that you don’t own?

 

This is the beauty of short selling: you can borrow shares from your broker or other third parties for a period of time. In exchange for borrowing the shares, which are immediately sold, you will pay a charge to the lender. As the lender will eventually regain ownership of the shares, this is a handy way of making additional income on long-term investments.

 

Margin accounts

 

Many people will be surprised to learn that short selling is a widespread activity across major global markets. You would typically run a margin account parallel to your short position to ensure you can honour your position. The margin account would contain the proceeds from the short sale and a degreeof insurance (margin) to cover any potential liability.

 

The margin amount would fluctuate depending on the share price. If the price moves higher, you may need to increase the margin to cover the potential liability. As with any marginaccount, if you fail to fulfil your margin requirements, the stock would be purchased, the position closed, and any outstanding balance due to your broker.

 

Short selling and liquidity

 

In the past, we have seen unscrupulous traders carrying out what are known as "bear raids", selling stock short, spreading rumours and then buying back when the price falls. Obviously, as a form of market abuse, this is illegal. However, carried out correctly, short selling can significantly increase a particular stock's liquidity and help maintain "fair value" - a form of arbitrage.

 

If, for example, investors pushed the price of a share to unsustainable highs, maybe after a surprisingly positive set of results, selling stock short would help rein in this exuberance and return the price to nearer fair value. In addition, selling stock into the market increases liquidity and can help avoid, or at least reduce, extreme levels of volatility.

 

The downside to short selling

 

The obvious downside to short selling would occur when the share price continues to rise, creating potentially unlimited losses. The longer you remain short of a rising stock, the more margin is required, the greater the payments to the lender and the higher the risk. You will often hear of short-sellers closing out, which means they are buying back the original shares to close their position. If the shares are in demand, each short seller closing their position could push the price higher and exacerbate losses for other short-sellers.

 

Short selling is not for everyone

 

Short selling activities are heavily regulated and potentially risky, but when using stop-loss limits, as with other investment strategies, this can limit the downside. Nevertheless, it is essential to be aware of the potential risks when selling short and the fact that even if you are right in your assumption, timing may not be on your side.

 

The mechanics of short selling

 

The process of short selling is the same as selling any other investment, aside from the fact that you have borrowed shares from a third party. Consequently, day traders looking to take advantage of overbought positions will often work on relatively thin margins. However, we can offer a competitive charging structure due to our ongoing investment in new technology, trading platforms, and electronic settlement systems.


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