What Is Short Selling? Selling Stocks Short ExplainedSummary: Most of the 'action' on a stock market appears to be investing for the long-term and backing a positive future. But not every fund or individual stock market investor believes in a rosy outlook. This page tries to explain what is short selling and the role it plays in a healthy stock market index. So, what is short selling? Any short selling definition needs to explain the basic mechanics of the market. Simply, most people (and funds) buy stock market assets hoping that company profits will increase and that sooner or later, the stock price will follow upwards. However, it cannot be that everyone thinks that every company share price will go up all the time for ever. Can it? No, it can't. For those that think that a company quote, sector or index is overvalued and should fall in price, it is possible to 'back the loser' as it were. In these circumstances, the investor (though it is normally a trading strategy as opposed to an investment strategy) can 'sell' the company or index and make a profit if they are right and prices do indeed fall. There are several mechanisms available for selling short. The more traditional method is to sell the stock in the market but at the same time 'borrow' the same amount of stock from another source. This method can be quite complicated and in many countries - and on many markets - is either frowned upon or actually banned. (During the 2008 banking meltdown, short selling was temporarily banned in many countries.) When the borrowed stock is repurchased in the market (it was already sold), it will hopefully be bought back at a lower price than the original sale, netting a profit which is the difference between the prices.
Options trading and spread betting are both high risk strategies - though short selling is not usually for the faint hearted - and will involve 'margin calls' if the trade goes against the trader. These margin calls are to protect the opposite side of the trade since leverage (borrowing) is used. Many funds will use short selling as a method of portfolio diversification and risk reduction. To the layman, this is called ' hedging '. Hedging normally involves using options to take an opposing stance on a stock index. This means that if prices move to far against the fund, the fund will not be overexposed and far catastrophic losses. Traders would tend to take a stance and avoid this hedging position. This would be known as naked short selling and is much higher risk. The rules for short selling are actually surprisingly lax. Though this does in part reflect the fact it is banned in many places. In the aftermath of the 2008 financial crisis, there are calls for 'greater' regulation, though whether this will actually work remains to be seen. Since most large scale short selling is carried out by hedge funds - that are global in nature and are designed to be difficult to regulate - it is not easy to imagine how rules would or could work. Your author was recently asked an interesting question, "Did short selling stocks cause the 2008 banking collapse?" This is actually a very interesting subject because the impact of short selling in a market is usually not noticeable - it is an integral part of daily life. However, it played a significant role in the collapse and near collapse of many well known financial companies. How can this happen? Banking as an industry and profession is based on trust. When trust is broken and lost, depositors remove their investments, loans are called in, new loans are not granted, shares are sold and business models crack under the strain. There were clearly many that could see that modern banking business models were not as sound and solid as they once were. By short selling shares in very large quantities, many hedge funds were betting that sooner or later these business models would come completely unstuck. In time, that is exactly what happened. The short selling was part of a vicious circle which dragged the poorly capitalised banks downwards. As their share prices fell under heavy short selling, investors sold their holdings in increasing numbers. This pushed stock prices down further causing further selling as stop losses were breached. At the same time, business models were coming under increasing pressure.
As these forces converged, other banks that were lending money began to lose trust in their higher risk counterparts. As they stopped lending short-term money, credit markets froze and banks became instantly insolvent. This of course, made the heavy short sellers significant amounts of money. One example of such a fund is run by Crispin Odey in the UK. Mr Odey's fund became quite famous after the Bradford and Bingley Building Society was nationalised and it became known that his fund had been selling the shares short for several years. It is worth pointing out that these events were highlighted by the weaknesses in the business models of banks and their importance in the modern economic structure of the world. In contrast, it is difficult to imagine that if a cement manufacturer were to be sold short and then cease trading that the entire property market would collapse! To read more about related subjects, please follow these links:
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