How small investors can step into the world of short selling and the risks involved
How retail investors can benefit using shorting opportunities as an investment method
Short selling is a fairly simple concept: An investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender.
Short sellers are betting that the stock they sell will drop in price post sale. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender.
Short-selling is exactly the same principle of “buy low, sell high,” just in the reverse order — you sell high and then buy low.
You may be wondering, how can you sell a stock before you buy it? It’s actually not as difficult as it seems.
To sell a stock that you don’t own, for example, you must first borrow it. Your broker facilitates this process and may let you borrow a stock owned by another trader or, less frequently, owned by the broker himself.
When you’re ready to exit your short position, you cover the position by buying back the stock you had shorted. In other words, selling before you buy really means you’re borrowing the stock before you short sell it.
You may be wondering, how can you sell a stock before you buy it? It’s actually not as difficult as it seems.
Here is an illustration to help make the concept simpler and clear any doubts on the topic.
Therefore, the investor borrows 100 shares from a broker while short selling those shares to the market. So now the investor “shorts” 100 shares of Stock A which he did not own with hopes that the share price will decline.
A week later, Stock A’s price falls to Dh90 per share after the company announces annual earnings.
The investor decides to close the short position, so he buys back 100 shares of Stock A from the open market at a price of Dh90 per share and returns those shares to the broker; this is a ‘buy-to-cover’ order.
Therefore, the investor makes a profit of Dh10 per share which is a total of Dh1,000 for the whole transaction, not including commissions and interest.
However, if the stock price increases to Dh110 per share and the investor decides to close the short position, he will need to buy-to-cover the 100 shares from the open market at the current price of Dh110 per share.
The loss for this short sale transaction will be Dh10 per share which amounts to a total loss of Dh1000 (excluding commissions and interest), since the stock shares were bought back at a higher price.
So, here is what we have understood so far. At the most basic level, short selling is essentially making a prediction that a stock will go down rather than up.
Here is a summary of how it works.
The goal is to re-buy those shares of stock at a lower price in the future and then return the borrowed shares to the lender.
Short sellers are hoping they can profit from the difference between the proceeds from the short sale and the cost of buying back the shares, referred to as short covering.
Again here is another similar yet simple example.
A short seller borrows 100 shares of a stock at a current price of Dh75 a share. The shorter immediately sells the stock for Dh7,500 (75 times 100).
Then, as the short seller had hoped, the price drops to Dh50 a share. So the short seller buys 100 shares for Dh5,000 and returns the shares to the lender. The profit is Dh2,500 (minus the interest or fees).
It’s up to the broker to decide if the stock in question can be shorted
But further to this instance, remember it’s up to the broker to decide if the stock in question can be shorted, as they’re the ones who have to find shares to lend to the trader.
Typically this is done automatically, and the broker will also automatically take their shares back as soon as a short is covered.
While short selling can be an extremely handy and profitable tool for traders under the right circumstances, it also comes with its fair share of unique risks.
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Caveats of short selling
Right off the bat, it is important to know that short selling comes with amplified risk. When an investor buys a stock (or goes long), they stand to lose only the money that they have invested.
However, when an investor short sells, they can theoretically lose an infinite amount of money because a stock's price can keep rising forever, unless the investor cuts his or her losses by buying just when it starts moving in the opposite direction to what he hoped for.
So to begin with, short selling is inherently more risky than traditional stock buying because possible losses far exceed possible gains.
Right off the bat, it is important to know that short selling comes with amplified risk
When buying a stock, potential losses are capped at 100 per cent of the original investment and potential gains are unlimited. When shorting a stock, the maximum gain is capped at 100 per cent of the original investment, and the potential losses are unlimited.
These buy-ins can occur when the lender of the stock demands it be returned, regardless of whether it’s an inopportune time for the short seller.
Now that we have briefly brushed through the concept and the risks involved, let’s explore in detail how shorting works in the real world and how a retail investor can benefit from it.
Hidden costs of short selling
Short selling comes with a number of costs that typical stock buying does not.
Short sellers are charged stock borrowing costs that can exceed the value of the short trade if a stock is particularly difficult to borrow.
Because short selling can only be done in margin accounts, short sellers must also pay margin interest on their positions. Let’s illustrate the concepts of margin accounts and margin interest through this next example.
Margin trading when shorting: an illustration
Take a look at a hypothetical situation involving a stock currently trading at about Dh50 per share. You've been doing some research and think that at some point in the future the price of that stock will fall.
So you sell "short" 100 shares at Dh50 per share in your margin account. This trade generates Dh5,000, part of which you're required to post as collateral.
The amount of collateral you're required to post depends on a range of factors and may vary from trade to trade. In the meantime, you borrow the shares with the assistance of your broker, which your broker then delivers to the clearance agency on the date the trade settles.
If the stock should lose value, trading down, for example, to Dh40 per share, you may decide to buy those 100 shares back, also known as covering your short, at a total cost of Dh4,000.
In this scenario, your trade has generated a gross profit of Dh1,000, not including costs such as brokerage commissions.
In this scenario, your trade has generated a gross profit of Dh1,000, not including costs such as brokerage commissions.
However, there's also a chance that the stock you've chosen to short could increase in value.
Say, for example, that the stock price instead rose to Dh60 instead of falling to Dh40. In this scenario, when you cover your short, your total cost would be Dh6,000, resulting in a Dh1,000 loss.
When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral.
Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement.
If your account slips below this, you'll be subject to a margin call and forced to put in more cash or liquidate your position.
Margin interest can be a significant expense when trading stocks on margin.
Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.
In most cases the margin requirement is 35 per cent, but, depending on the stock involved, your broker could raise that requirement to 70 per cent.
If market fluctuations reduce the value of the equity in your account, your broker may issue a margin call, which you must meet by adding funds to your account.
Failure to meet a margin call could result in your broker either selling securities in your account or buying in your short positions without consulting you, even if the trade is currently going against you.
Shorting in the real world
The stock market has been on quite a rise in the past decade or so, and a large number of traders are betting that what goes up must come down.
Inexperienced traders often stick to the objective of buying low and selling high, but short sellers recognise that selling high and buying low can be just as profitable.
If the companies don’t operate well, short sellers will bet against them.
In this view, short selling is seen as desirable because it forces companies to be accountable for their errors—which is supposedly good for the economy in general.
Short selling is seen at times desirable because it forces companies to be accountable for their errors.
Whether one likes it or not, it is hard to see how securities markets could exist without winners and losers, without some investors having different appraisals of particular companies than other investors.
So, short selling seems to be part of the necessary operations of financial markets.
Why short selling is bad?
Because short selling can be so risky many analysts warn against it. Here are some of the repercussions.
• Excessive shorting leads to volatility
Also, when there is significant short selling of the stock of a particular company, the short selling itself may cause the value of that stock to fall.
Again, the problem is excessive gyrations of securities markets.
• Some use it to game the system
Short selling—or, more generally, betting against a security—becomes a real problem when used in ways to game the system.
One of these ways is called “short and distort”.
A large investor—a hedge fund, for example—can short the stock of a company and then undertake a campaign to discredit the operation of the company.
If the campaign generates a fall in the price of the company’s stock, the investor wins—but not because of any real weakness of the company.
Believing these CDOs were good investments, presumably because Goldman Sachs was urging their purchase, the clients spent billions buying them. For a while the clients made money off these investments.
Then top Goldman executives in December 2006 reportedly decided to change the firm’s overall stance on the mortgage market, from positive to negative, but did not tell its clients.
So Goldman Sachs started making CDO investments (i.e., shorting the CDOs) that would pay off only if the housing bubble deflated.
When the housing market started to go bust and the CDOs did fall in value, Goldman Sachs made billions and its clients lost billions.
Goldman Sachs was not the only financial institution to profit from this sort of duplicitous practice. Others, reportedly included Deutsche Bank and Morgan Stanley, as well as some smaller firms.
Years later at a US Congress’ investigatory hearing into the financial crisis, the committee chair, Phil Angelides, confronted the head of Goldman Sachs, Lloyd Blankfein, on this issue, and put it aptly in a way that somebody seeking to study short selling can relate to:
“I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars. It doesn’t seem to me that’s a practice that inspires confidence in the market.”
Read more about mortgaged-backed securities and collateralized debt obligations here:
FAQs: Using shorting as an investment, legalities
Now let’s go to some of the questions you might have at this stage.
• Can retail investors benefit from shorting opportunities?
Yes, retail investors can benefit from shorting opportunities as an investment method, and here is how.
As a retail investor you can short equities, but you will need a margin account. A margin account is a type of account where the brokerage firm can borrow your money to buy/short securities.
Equities can be shorted as long as your broker and the corresponding clearing firm have shares available to borrow (‘easy to borrow’).
Most retail brokerages do offer margin accounts but may impose higher capital requirements.
When the clearing firm does not have shares available to borrow, they will mark the security ‘hard to borrow’ and you will not be able to short it.
• Is short-selling legal despite its risks and why?
Short selling remains legal in most stock markets, unlike so-called 'naked short selling' — shorting without having first borrowed the shares.
Despite its legal status and the apparent benefits of short selling, many policymakers, regulators – and the public – remain suspicious of the practice.
Being able to profit from the losses of others in a bear market just seemed unfair and unethical to many people.
The country’s exchange commission SEC did form a rule that allowed unrestricted short selling when the market was moving up, which increased market liquidity, and acted as a check on upside price swings, but later abolished the rule after concluding that regulations did little to curb abusive behaviour.
But since the 2008 recession and stock market crash, the US SEC brought back the rule but tweaked it. The alternative rule, which does not apply to all securities, is only triggered by a 10 per cent or greater price drop from its previous close. But most of the regulators in other regions do not have any such rule.
Another prohibited activity is to sell short and then fail to deliver shares at the time of settlement with the intent of driving down an asset’s price.
However, when short-selling goes out of control – contributing to severe volatility in the market – governments and regulators can sometimes impose restrictions in an effort to help stem the slide.