What is short selling and how does shorting work?

What is short selling?

Short selling is the practice of selling a borrowed asset to profit from an anticipated price decline. While commonly associated with stocks, short selling extends to various financial markets, including forex and commodities. For instance, a trader expecting a drop in oil prices might "go short" oil using instruments like CFDs or futures contracts.

What is shorting a stock?

Short selling a stock is a strategy that involves borrowing shares from a broker in order to sell them. Traders do this to benefit from a decline in the share price. Once the price has reached the target level, the trader will repurchase the stock at a lower price, closing out the short position. The borrowed shares are returned to the broker, and the trader keeps the price difference as profit.

Let's say company ABC's shares trade at $100. Trader A believes the upcoming earnings report will be disappointing, driving the price down. To profit from this, Trader A short sells 100 shares at $100.

The earnings report is indeed weak, and ABC's share price falls to $80. Trader A then buys 100 shares at $80 to close their short position.

Trader A's profit is $20 per share ($100 selling price - $80 buying price), for a total profit of $2,000 (100 shares x $20 profit per share).

What does it mean to short a stock?

The term "short selling" refers to the practice of selling something you do not actually own. If you do not own shares of a company, you logically cannot sell them, i.e., you are "short" the amount that you wish to sell.

This is where brokers step in—they enable traders to sell shares (or other instruments) that they do not actually own, in exchange for a commission charge or spread.

What is a short seller?

A short seller profits from a decline in an asset's price. They can be short-term speculators, like day traders targeting intraday price drops, or long-term investors holding positions for months.

Deep-pocketed activist investors have the ability to maintain their short positions for even longer periods. For example, hedge fund manager Bill Ackman was involved in a five-year battle against Herbalife and continued to bet on a decline in its share price for a period of 5 years.

Thus, short sellers can have different strategies and time goals, but they have one common objective—to profit from an asset’s falling price.

What is a short squeeze?

A short squeeze occurs when a rapid price increase compels short sellers to cover their positions to prevent further losses. This can happen across various financial markets, including currencies, commodities, and stocks.

These squeezes typically arise when an asset has attracted significant short-selling activity. A sudden price rebound, often prompted by a market event, triggers the squeeze. As the price climbs, short sellers' stop-loss orders are activated, and others manually exit their positions. This resulting buying pressure further accelerates the price climb, triggering additional stop-loss orders and reinforcing the upward momentum.

Example:

Company XYZ's stock price has declined over several months due to negative news, attracting a large number of short sellers who anticipate no recovery. However, the company unexpectedly announces a groundbreaking product likely to significantly increase market share and sales. This surprise announcement triggers a sudden price jump as buyers see an opportunity and enter the market. Short sellers, facing substantial losses, rush to cover their positions, initiating a short squeeze.

Why would anyone short a stock?

Many types of market participants are involved in short selling, but they have a common goal, which is to profit from a decline in an asset’s price.

There are several reasons why investors engage in short selling:

1. They believe that an asset has reached its peak in value. For example, an investor believes the AI boom that massively inflated the share prices of tech companies is ending and thus is going short the NASDAQ 100 index.
2. They think an asset will be negatively impacted by upcoming news. For example, an investor might be confident that company ABC's next earnings report will miss market expectations and include a pessimistic outlook.
3. They believe an asset is fundamentally worthless. Activist investors, for instance, might consider a company worthless due to a flawed business model, poor management, or even fraudulent practices.
4. They want to hedge. An investor who feels that his/her portfolio is heavily exposed to a particular sector might engage in short-selling a related product to reduce his/her exposure in the short term.

How does short selling work?

Short selling allows a trader to borrow the underlying asset from a broker in order to sell it at the current market price. If the stock price falls, you can buy it back at a lower price and return it to the lender (broker) while pocketing the difference as profit. However, if the share price rises and you are forced to liquidate your short position at a higher price, you will realise a loss.

How short selling works depends on the product type. Physical shares will involve borrowing them from a broker. On the other hand, CFDs are derivatives and do not involve the exchange of the underlying asset, which simplifies the process.

How to short a stock?

To short sell a stock, you will require a margin account with a broker. Not all brokers will necessarily allow short selling of physical shares, as the process differs from buying shares and requires collateral.

Once you have a margin account with a broker that allows short selling, you can analyse the markets and identify stocks that you believe will decrease in price. Short selling might not work in some cases, for example, if there is a low supply of shares available.

If the stock is available for short selling, your broker will facilitate the trade and charge a fee for this service. Once the shares have been borrowed from your broker, you can sell them at the current market price.

At some point, you will cover your short position and return the shares to your broker, either at a profit or a loss for your account.

When short selling stocks, it is important to be mindful of the fees that the broker charges and the margin requirements.

Short selling example: GameStop stock

GameStop is a US-based video game and electronics retailer that attracted plenty of attention in 2021. The company was struggling during the 2010s and suffering from the decline of brick-and-mortar shops.

Hedge funds started to build up significant short positions, betting that the share price of the company would decline further. The short interest reached extreme levels, exceeding 100% at some point, which means more stocks were being shorted than actually existed.

The significant short interest in GameStop attracted the attention of retail traders, who gathered in a Reddit forum called “r/wallstreetbets.” These retail traders started to buy shares of GameStop in anticipation of a short squeeze, and as the story went viral, upside momentum was strong enough for them to force institutional investors out of their positions.

A dramatic short squeeze occurred, with the share price of GameStop rising from $20 to a high of $483 in January 2021 (the price appears lower now due to a stock split). The surge in GameStop’s share price attracted a lot of attention as it became a symbol of retail investors being powerful enough to take on institutional investors when united in a large number.

The biggest victim of the GameStop saga was a US-based hedge fund called Melvin Capital, which had a large short position. Melvin suffered from a loss of almost 50% at the beginning of 2021 and required a bailout. It eventually shut down a year later.

Who is the typical short seller?

While short selling is common among institutional investors, including hedge funds and investment companies, retail investors can also participate.

Hedge funds are particularly known for their short-selling activities, often due to their large and publicly disclosed positions. While some hedge funds employ a more discreet approach, others, like Bill Ackman with Herbalife, take a more public and aggressive stance.

Other investment firms, such as mutual funds, also engage in short selling, though typically less aggressively and often for hedging purposes.

Activist short sellers

Activist short sellers, while also profiting from declining share prices, differ from short-term speculators by actively seeking to influence the targeted company, often through public campaigns. They typically target companies they believe are significantly overvalued due to various issues, ranging from mismanagement to fraud and illegal activities. Hindenburg Research LLC, a well-known activist short-selling firm, exemplifies this approach. For example, their 2020 report accusing Nikola Corporation of fraud triggered a 40% drop in Nikola's share price.

In 2023, Hindenburg targeted the India-based Adani Group, alleging significant accounting errors and market manipulation.

Activist short sellers are a controversial subject. Some praise them for driving positive change and exposing critical issues, while others criticise their tactics as manipulative and deceptive.

Advantages of shorting

1. Gives investors the ability to profit from falling share prices, not just from rising prices.
2. Provides investors with the ability to hedge their market exposure.
3. Increases market liquidity.
4. It can help investors diversify their portfolios and trading strategies.

Risks of shorting

1. Unlimited loss potential: Unlike buying a stock, where the maximum loss is the initial investment (the stock price falling to zero), short selling's potential losses are theoretically unlimited. While the maximum profit is capped at the initial stock price (if it becomes worthless), the stock price could rise indefinitely, leading to unbounded losses for the short seller. For example, shorting a $50 stock yields a maximum profit of $50, but losses can mount if the price rises to $100, $1,000, or higher.
2. Short squeezes: Unexpected market events or news can trigger a short squeeze, forcing short sellers to cover their positions at a loss.
3. Costs and fees: Borrowing shares from a broker involves fees, costs, and margin requirements that short sellers must consider.
4. Short-selling bans: Governments or regulatory bodies can impose short-selling bans with little notice, potentially trapping short sellers in their positions.

Short selling strategies

Short selling strategies generally fall into two categories:

Fundamental short selling focuses on shorting a company’s stock based on fundamental weaknesses. These could include inefficient management, unsustainable debt, a poor earnings outlook, or negative industry or company-specific changes.

Technical short selling uses chart patterns and technical indicators. For example, a bearish chart pattern or a stock in overbought territory (e.g., with a Relative Strength Indicator above 70) might signal a shorting opportunity.

Key takeaways

In conclusion, short selling involves borrowing shares from a broker to sell at the current market price, hoping to profit from an anticipated price decline. If the price falls as expected, the short seller can repurchase the shares at the lower price, realizing a profit.

Both retail and institutional investors engage in short selling, though institutional investors, especially hedge funds with their often-substantial positions, are more prevalent in this practice.

While short selling offers the opportunity to profit from falling prices, it also carries substantial risk, including unlimited potential losses and the possibility of a sudden short squeeze.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.