What Is Short Selling? Selling Stocks Short Explained

Summary: 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, forever. 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, including much of Europe). 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.

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Another mechanism that is much easier for the private investor to access is by using options or spread betting. These methods use companies to match trades - as a stockbroker would - between counterparties. This helps to reduce the risks for both sides of the trade and generates profits for the company in the middle.

There are typically very large amounts of short sales at any given time on most major exchanges. However, as any astute follower of the stock exchange will know, these positions are very rarely discussed. The talking heads of MSNBC and CNN don't tend to discuss the downward trades too often. Similarly, the Wall Street Journal and other publications do not focus much attention on them.

Why not?

A very large percentage of the short positions are placed by hedge funds and they spend a great deal of effort trying to keep their positions a secret from their competitors. Thus, the short side of the market can be quite opaque.

Risky business

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. This means that the broker requires more cash to keep the trade open because the deposit placed is no longer enough to cover the position. In other words, the trader has lost his original stake.

This is not something that you will be advised to do by your financial planner. By definition, short sales are high risk (since they go against the general trend of human nature which is to be optimistic and against the overall nature of the market which is that people and funds buy stocks) and are more likely to be the preserve of professionals (day traders or money managers).

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 face 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. After all, to sell the NYSE or NASDAQ, a fund, or company does not need to be based in the United States...

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.

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Many banks were borrowing heavily in the short-term but investing the money for the long-term. This meant that they had regular liabilities that needed more borrowed money, but their assets were difficult to liquidate. Not only were their holdings in long-term assets, but many had no actively traded market meaning that selling was often impossible. (In some asset classes, such as derivatives and mortgage securities, it is fiendishly difficult to value an asset in part because of the incredibly complicated contracts. Something that difficult to value and assess will be very hard to sell.)

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!

A hedge fund battleground

On a few occasions, companies become the playthings of billionaires involved in power games. An example is underway as I write in August 2013. An American nutritional company, Herbalife, is the battleground between rival hedge fund managers, Bill Ackman and Carl Icahn.

Ackman, manager of Pershing Square Capital Management, announced publicly that he was shorting Herbalife with a target price of $0. This lead some of his rivals (particularly Icahn) to investigate the company and take long positions, hoping to trap him in what is known as a "short squeeze".

As is explained in this article, Ackman did not cover his position with even a single share (therefore he is naked, as explained above) and it is costing his fund a lot of money. According to the article, the shares are up by 41% since he announced his position.

This situation is an example of what can happen to a good company. There are hedge fund titans playing a high risk power game with the company and the company is at great risk simply because of the powerbrokers pulling the strings. Personal animosity has the potential to seriously damage a firm that employs around 35,000 people. In other words, this is not a great example being set for short selling...

To read more about related subjects, please follow these links:

Understanding Bull And Bear Market Situations

Bear Market Definition

What Is A Bear Market?

Bear Market Investing Strategies

Secular And Cyclical Bear Markets

The Great Crash 1929 by J.K. Galbraith

What Caused The 2008 Financial Crisis?

What Caused The 2008 US Stock Market Crash?

What Caused The Fall Of Lehman Brothers?