If you think share prices are set to drop, you don’t have to lie down and take the pain. Instead, you can profit from any fall using a process called short selling.
Short selling is where you sell a share you have borrowed, expecting to repurchase it at a lower price for a profit. Your profit is the difference between the prices at which you sell it and buy it back. Or, if your prediction is wrong and the share price rises, this difference will be the amount you lose.
Suppose you think Tesla is overvalued at USD 800 a share and its price will fall. To short that stock, you would borrow 10 Tesla shares from a broker, then sell the shares for the current open market price of USD 800. If the stock falls to USD 500, you buy 10 Tesla shares back at this price, return them to the broker, and make a profit of USD 3,000. However, if Tesla's share price rises to $1,000, you lose USD 2,000.
Another reason for ‘going short’ would be to hedge or protect gains on other ordinary share holdings, or compensate for losses. For example, if an investor wants to protect gains in a stock that is vulnerable to price swings in its region or industry, they might keep the stock but buy an exchange traded fund that has gone short across that region or sector. A loss on the shares would then be offset by gains on the ETF.
Short selling can be controversial, especially when institutional investors such as hedge funds have put downward pressure on a stock, or even a whole market, for their own benefit. But this is becoming less prevalent as other investors have started to fight this, as happened with the much-reported GameStop affair early in 2021.
This argument aside, most economists now believe shorting is an important mechanism in markets. Short sellers contribute to the liquidity and efficiency of markets because they sell overpriced stocks and thus trigger a correction that returns them to their correct value. This allows for more accurate, realistic pricing and prevents market bubbles. Also, short sellers often play a pivotal role in exposing bad companies and corporate criminals.
Rencheng Wang, associate professor of accounting at Singapore Management University, wrote a 2021 paper on the impact of short selling on markets. He said: ‘Short sellers play a critical role in detecting overvalued firms on which other investors have made bad or opportunistic decisions. For example, research shows short sellers detect around 15% of corporate frauds. The threat of short sellers also lowers a potential bad actor’s incentive to behave opportunistically at the expense of outsiders.’ This is because short sellers’ research activities increase the risk of detection and negative consequences for the bad actor.
Short selling is risky but the profits can be large. Profits from short selling at the beginning of the Covid pandemic in 2020 totalled $1 billion in one week for Tesla stock alone, according to Statista.
However, Tesla also generated -$40 billion losses for short sellers in 2020 overall, due to its spectacular price rises throughout the rest of that year. The next highest lossmaker for short sellers in 2020 was Apple with -$6.7 billion.
Wang said: ‘Short selling is not easy and only sophisticated investors can play it well. It amplifies risk substantially. When an investor buys a stock, they stand to lose only the money they invest because the stock cannot drop to less than zero.
‘But, when investors short sell, they can theoretically lose an infinite amount because a stock's price could keep rising forever.’
Ways to avoid or mitigate this risk include having a diversified basket of short positions on shares or indexes, and taking a disciplined approach to cutting your losses if your prediction is wrong and the price of a share you short rises. Asking the advice of your wealth manager could also help as they will likely be more familiar with these instruments.
Another less risky way of betting on a fall is to buy a so-called put option. This gives the investor the right to sell the underlying asset at a stated price, with the maximum loss being the premium paid for the option.
There are also now products available to retail investors that offer short strategies on selected share indexes, but which cap losses to the size of the original investment.
Short sellers have been around for centuries, but the concept exploded into the public consciousness when US investor George Soros became known as ‘the man who broke the Bank of England’ in 1992. He made $1.1 billion by shorting the pound when the bank was trying to over-ambitiously inflate the currency, but eventually had to reverse its actions.
More recently, the publication of ‘The Big Short’ by Michael Lewis in 2010, and the 2015 movie, glamorized the concept further. This told the breath-taking story of a group of investors who made billions by shorting the US housing market before it started to collapse in 2007.
Short selling has now also arrived on Netflix: Fahmi Quadir was nicknamed The Assassin for her work in uncovering corporate criminals, and appeared in the 2018 Netflix documentary Dirty Money.
Cover picture: © Shutterstock
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