Short Selling

MoneyBestPal Team
By : personMoneyBestPal Team
March 04, 2023
A trading strategy used by investors who anticipate that the price of a security will decline in the future.
Image: Moneybestpal.com

Main Findings

  • Short selling is an advanced trading strategy that involves borrowing and selling a security that is expected to decline in price.
  • Short sellers aim to profit from buying back the security at a lower price and returning it to the lender.
  • Short selling can be used for speculation or hedging purposes, but it also entails significant risks and challenges.


Short selling is an investment or trading strategy that speculates on the decline of a stock or other security's price.


It involves borrowing a security from a broker and selling it in the market, hoping to buy it back later at a lower price and return it to the lender. The difference between the sale price and the repurchase price is the short seller's profit or loss.



Why short selling?

Short selling can be used for different purposes, such as:

  • Speculation: Short sellers can profit from a drop in a security's price, especially if they expect it to be overvalued or face negative events.
  • Hedging: Short sellers can reduce the downside risk of a long position in the same or related security, by offsetting potential losses with gains from shorting.
  • Arbitrage: Short sellers can exploit price discrepancies between different markets or instruments, by simultaneously buying and selling the same or equivalent securities.
  • Market correction: Short sellers can provide liquidity and price discovery to the market, by preventing excessive optimism and exposing fraudulent or weak companies.



Formula for short-selling

The formula for calculating the return on a short sale is:


Return = (Sale Price - Repurchase Price – Costs) / (Sale Price)


Where:

  • Sale Price is the price at which the borrowed security is sold in the market.
  • Repurchase Price is the price at which the borrowed security is bought back in the market.
  • Costs are the fees, commissions, interest, and dividends paid by the short seller.



How to calculate short selling

To illustrate how to calculate short selling, let's use an example:

Suppose an investor believes that XYZ stock, currently trading at $50 per share, will decline in price in the next three months. They borrow 100 shares from a broker and sell them in the market, receiving $5,000 in proceeds. The broker charges an interest rate of 10% per year and a commission of 1% per trade. The investor also has to pay any dividends declared by XYZ during the short period.


After three months, XYZ stock drops to $30 per share, and the investor decides to close their position. They buy back 100 shares in the market, paying $3,000 plus a commission of 1%, or $30. The interest charged by the broker for three months is $125 ($5,000 x 10% x 3/12). The dividend paid by XYZ during the period is $0.50 per share or $50 in total.


The return on the short sale is:


Return = (5,000 - 3,000 - 30 - 125 – 50) / (5,000) = 0.359


The investor makes a profit of $1,795 ($5,000 - $3,205), or 35.9%, from shorting XYZ stock.



Examples

Some examples of short selling are:


George Soros and the British Pound

In 1992, George Soros famously shorted the British pound, profiting around $1 billion when the pound crashed out of the European Exchange Rate Mechanism.



David Einhorn and Lehman Brothers

In 2007, David Einhorn, a hedge fund manager, publicly announced his short position on Lehman Brothers, a global financial services firm. He criticized the firm's accounting practices and leverage levels, and warned of its impending collapse. He was proven right in 2008, when Lehman filed for bankruptcy, triggering a global financial crisis.



Bill Ackman and Herbalife

In 2012, Bill Ackman, another hedge fund manager, revealed his $1 billion short bet on Herbalife, a multi-level marketing company that sells nutritional products. He accused the company of being a pyramid scheme and predicted that its stock price would go to zero.


However, his bet backfired as Herbalife's stock price rose instead, boosted by the support of other prominent investors such as Carl Icahn and Daniel Loeb. Ackman eventually closed his position in 2018, admitting defeat and suffering huge losses.



Limitations

Short selling has several limitations that make it a risky and challenging strategy. Some of these are:


Unlimited losses

Unlike buying a stock, where the maximum loss is the amount invested, short selling exposes the trader to unlimited losses, as the price of the stock can rise indefinitely. For example, if a trader shorts 100 shares of a stock at $10 per share, and the stock rises to $50 per share, the trader would lose $4,000 ($5,000 - $1,000), or 400% of the initial investment.



Margin requirements

Short selling requires borrowing shares from a broker-dealer through a margin account. The trader must pay interest on the borrowed shares and maintain a minimum amount of equity in the account, known as the maintenance margin.


If the equity falls below this level, the trader will face a margin call and will have to deposit more funds or close the position. Margin requirements can vary depending on the broker and the volatility of the stock.



Short squeezes

A short squeeze occurs when a large number of short sellers try to cover their positions at the same time, driving up the price of the stock. This can happen when there is positive news about the company or the market, or when there is a high demand for the stock from other buyers. A short squeeze can force short sellers to close their positions at a loss, further fueling the price increase.



Regulatory restrictions

Short selling is subject to various rules and regulations that aim to prevent market manipulation and protect investors. For example, in the U.S., short sellers must abide by the uptick rule, which states that a stock can only be sold short when its price is higher than the previous trade.


This rule is intended to prevent short sellers from driving down the price of a stock by selling large quantities of it. Additionally, some stocks may be hard to borrow or unavailable for short selling due to limited supply or high demand.



Conclusion

Short selling is an advanced trading strategy that involves borrowing and selling a security that is expected to decline in price. Short sellers aim to profit from buying back the security at a lower price and returning it to the lender.


Short selling can be used for speculation or hedging purposes, but it also entails significant risks and challenges. Short sellers face unlimited losses, margin requirements, short squeezes, and regulatory restrictions that can limit their potential returns or cause them to lose money.



References


FAQ

Short Selling is an investment strategy where an investor borrows a security and sells it on the open market, planning to buy it back later for less money. Short sellers bet on, and profit from, a drop in a security’s price.

The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity. It’s an advanced strategy that should only be undertaken by experienced traders and investors.

In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price.

The regulations for Short Selling vary by country. For instance, in Indonesia, the Indonesia Stock Exchange (BEI) has not yet opened transactions for short selling.

A notable event involving short selling occurred when retail investors in the United States drove up the price of GameStop shares, causing significant losses for hedge funds that had shorted the stock.

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