Short-selling: Here’s the long and short of this investment strategy
What do Tesla, Apple and Netflix have in common? Besides being large US-based technology companies, they were also the biggest targets of short sellers in 2019. Short selling is an investment strategy that is based off the falling price of a stock or investment asset. If an investor believes a stock’s price is going to rise, he will place a long(buy) position on the stock. If he thinks the stock price is going to fall, he would place a short(sell) position. Hence, from the name short selling, investors make a speculation to capitalize on the potential fall of underlying asset’s price. At other times, however, portfolio managers use this strategy to hedge against any downside risk on their existing long positions.
This investment strategy is often used by more advanced investors, because it comes with a significant amount of risk.
What is short selling?
You would have probably heard of this common investing adage, “buy low, sell high”. Short selling takes this piece of advice, and turns it on its head, by selling the stock or asset when it is at a high price first, then buying it again when the price falls.
How can you sell something before you buy it?
The investor has to first borrow shares of the stock or asset, sell it at the market price to other buyers, then wait for the price to fall before buying it back and returning it to the lender. In that manner, short sellers are counting on being able to buy the asset back at a lower price than they sold it at.
With a borrowing arrangement as described above, short selling is not available on regular stock market exchanges. Instead, short sellers have to opt for leveraged product markets, like Contracts for Difference.
Here are some of the key benefits and risks to short selling.
Benefits of short selling
- Trading in a bear market
In a bear market, where prices are falling, it would be counter-intuitive for investors to trade long positions over the short and medium term. Short selling offers an alternative method of trading, allowing you to reap returns while prices fall.
- Hedge against falling prices
For investors who have a long position on their investments, short selling allows them to hedge and profit from any short term price declines, while maintaining their long term view.
- Low initial capital outlay
Short selling is often performed in leveraged products where a smaller initial capital is required to start trading.
- Leverage multiplies your gains
When the asset price falls, your short will be profitable. With leverage, your gains will be manifold.
Risk of short selling
- Margin calls
In order to enjoy a low initial capital outlay on your short positions, you are required to maintain a margin account to trade. If your portfolio falls below your required maintenance margin, you will be subjected to margin calls, where you have to put in additional cash or pledge more equity into your margin account.
- Margin interest
When you borrow stocks or other assets for your short, you will need to pay margin interest, over the period that you are borrowing the asset. These interest payments will eat into your returns from your short, the longer your short position is held.
- Leverage multiplies your losses
While leverage multiplies your gains, you should also be clear that it can also multiply your losses, if the asset price goes against you.
- Regulatory bans
Short selling comes with a number of negative connotations, and regulators occasionally put a ban on short selling to stop prices from free falling. In March 2020, as the Covid-19 pandemic swept across Europe, several European countries like France, Italy, and Spain banned short selling to curb panic selling.
Such bans, which can be implemented without prior warning, can create a sudden surge in prices, leaving short sellers scrambling to close their positions and minimise their trading losses.
Knock-Outs to protect short sellers
Experienced short sellers are well aware of the risks they are taking in their trades, and are prepared for the margin calls, interest payments and even their potential losses.
However, it is far more difficult for investors to pre-empt sudden bans on short selling. This is a prospect that looks increasingly probable, as the Covid-19 outbreak continues to infect thousands, keep millions in their homes, and impacting the livelihoods of many more.
To protect themselves, short sellers can consider Knock-Outs to mitigate their risks taken during such situations.
If the market falls – in favour of short sellers – your trade remains open until you close it to take profit. If the market moves against you, your loss will be unlimited. In times like this, you can consider buying a bear Knock-Out , your trade will be knocked out at the level you indicate would be the maximum you would lose if the market goes against you, protecting you from making losses beyond your initial investment.
Learn more about knock-outs here.
The case for short selling
As governments attempt to curb falling markets by putting temporary bans on short selling, it might be easy to assume that short sellers are to blame. However, the evidence appears to suggest otherwise.
For one thing, prices continue to fall even when short selling is banned. This was the case in all four European countries mentioned earlier.
A report published by the Federal Reserve Bank of New York in 2012, found that the short selling bans implemented in the US in 2008 “had little impact on stock prices” and “even with the bans in place, prices continued to fall”. At the same time, the bans “lowered market liquidity and increased trading costs”. The short selling ban was estimated to have cost the U.S. equities options market an additional $500 million from September 18, 2008 to October 8, 2008.
Many have criticised short sellers as market manipulators, due in part to the actions of some infamous short sellers.
However, the majority of short sellers are not deserving of such names. Short selling helps to provide liquidity to the market, giving the market enough buyers and sellers. Short selling activity is simply an indicator of market sentiment – even if that sentiment is negative – and should be considered an integral part of the supply and demand dynamic within a healthy market.