What is short selling?

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February 03 2021
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Short selling has been a popular strategy for stock traders who are willing to take on the risk of capital loss, but the tactic’s fame has soared in recent weeks on the back of the GameStop saga. Here’s a basic explanation about this trading strategy.

Shorting stock or short selling involves an investor borrowing shares of a company (usually from a broker dealer), then selling that stock into the market. Short sellers are betting that the borrowed stock they sold will drop in price. If the share prices do indeed fall, then the investor will buy back those same shares at a lower price point.

The short seller then returns the stock to the lender and makes a profit by pocketing the difference between the sell price and buy price.

Why do people short sell?

Short selling is not used by many investors because the general expectation is that the stocks market will rise in value. The traditional investment strategy used in stock trading is to “buy low and sell high”. This is because historically, the sharemarket tends to rally, although there are certain periods when shares decline.

For investors looking at a long investment time horizon, buying stocks is considered to be less risky than short-selling the market. So, when is short selling advantageous? Short selling is usually used for speculation or hedging.

Speculators short sell to capitalise on the decline of a certain stock or security. An investor can take advantage of a shorting opportunity to profit from an overpriced stock or market. For example, an investor chooses to bet against a company stock that is likely to decline. It may be because a company is experiencing difficulties and could miss debt repayments.

Meanwhile, hedgers go short to protect gains or minimise losses. Hedge funds are prominent short-sellers in the markets and often utilise short positions in stocks or sectors to hedge their long positions in other stocks. This means they are protecting other long positions with offsetting short positions.

What are the pros and cons of short selling?

Knowing the pros and cons of short-selling stocks will help you decide if it’s the investment strategy that’s right for you.

Pros

Possibility of high profits. Short selling has a high risk/reward ratio: it’s a strategy that has high risk but also offers a high reward. If the seller predicts the price movement correctly, they can pocket a good return on investment.
Little initial capital required. If a seller uses margin to initiate the trade, it provides leverage to the seller. It means the trader did not need to put up much of their capital as an initial investment.
Hedge against other holdings. If done carefully, short selling can be an inexpensive way to hedge, providing a counterbalance to other portfolio holdings. Short selling allows an investor to hedge an existing portfolio’s long-only exposure and reduce the overall market exposure of a portfolio. Exposure to both long and short positions can reduce a portfolio’s overall volatility.

Cons

Potentially unlimited losses. As mentioned, selling short can be costly if the seller has the wrong predictions about the stock price movement. 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 infinitely.
Margin requirement. Short selling also requires that you put up margin. As with a margin buy (long) transaction, the percentage required varies depending on the eligibility of particular securities.
Margin interest incurred. Most brokers will charge their typical margin interest rates on a short position.
Trading restrictions. There are restrictions on the size, price and types of stocks you are able to short-sell. For example, you can’t short-sell penny stocks, and most short sales need to be done in round lots.
Short squeezes. Sellers can get caught in a short squeeze loop if a particular stock’s price begins to skyrocket. If a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of a short squeeze cycle. A short squeeze occurs when a stock starts to rise and short-sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares builds up buying pressure, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions.

Conclusion

When done right, short selling can give investors an opportunity to make profits in the short term. However, it should only be attempted by advanced traders due to its risk of infinite losses.

New to stock trading? Read our intro into the share trading to get started.

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