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The big deal on shorting shares

A look at how selling short works and what that means for the investor.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

For most people, investing means buying shares or bonds in the hope their price rises over time or to collect an income. They make money when the price rises, and lose money when it falls.

However, some sophisticated professional investors look to profit when prices fall through what’s called short selling. It’s a common strategy used by hedge funds and other institutional investors like pensions and insurance companies that buy securities in bulk.

While being able to profit on both the market's ups and downs might sound appealing, it’s a high risk strategy and most investors should stay clear. Short positions have potentially unlimited losses and require precise timing. High trading fees often make profits even more difficult to come by.

How shorting works

Investors who want to take a short position will borrow shares from a broker or other large investor and sell them on the market at the current price. If the stock declines as they’ve predicted, they can buy the shares back at a lower price and return the shares to the broker.

Take the example below:

IAG

Past performance is not a guide to the future. Source: Refinitiv, to 25/03/2021.

Imagine you were to borrow this stock to sell on the market when it was flying high at £4.00 per share. Two months later, you could buy it back for £1.30, return it to the broker and pocket the £2.70 difference, excluding any trading fees.

In hindsight, this looks like an appealing strategy. After all, it’s unlikely that a long position would boast that kind of return in such a short period. But what makes short selling problematic is the losses are potentially limitless, unlike traditional investing where you can’t lose more than you invest.

In reality if you invest in the stock market, what you’ll get will depend on the underlying investments and how they perform. You could lose what you invest and any potential income, so you could still make a loss.

Here’s another example:

Anadarko

Past performance is not a guide to the future. Source: Refinitiv, to 08/08/2019.

This is the share price of a petroleum company that had been struggling with cash flow as oil prices dropped. Say you borrowed shares and sold them on the market for $45 in April, expecting further declines ahead. A few days later the group became an acquisition target and a bidding war between two larger companies broke out. The stock surged to over $70 per share, leaving you with $25 of losses on every share in a matter of weeks.

Even a stock that seems destined to drop can rise if the conditions are right – that’s what makes short selling so dangerous. Everything from an acquisition to a Reddit-inspired frenzy can cause a short position to go sour quickly.

Short sellers don’t have diamond hands

Some short sellers will hold out when a stock rises in hopes it will come back down and make their trade profitable – or at least less unprofitable. But in order to do so, they have to prove they have the financial resources to repay their broker if their prediction turns out to be wrong.

Brokers typically require short sellers to maintain a minimum cash balance equal to the amount they’re owed. As a shorted share rises, the broker will up the minimum balance. If the investor can’t deposit the amount needed, the borrowed shares are recalled, forcing the investor to buy shares at the current market price. Institutional investors set similar limits for themselves in order to cap the losses they’re willing to take.

These minimum balances can trigger what’s called a ‘short squeeze’. When lots of investors have taken a short position on a particular stock and it begins to rise, some will try to buy shares to prevent further losses. This can push the shares up and can cause a chain-reaction, as brokers force more short sellers to close their positions. Thus creating a tailwind for an otherwise struggling stock, sending the price higher.

One of the most notable examples of a short squeeze was back in 2008, when for one day German car-maker Volkswagen became the most valuable company in the world. Days before, Porsche announced it had taken a 74% stake in VW voting shares, prompting acquisition rumours. The rising share price caused a cascade of buying as short sellers were forced to close their positions pushing the shares more than 300% higher.

Volkswagen

Past performance is not a guide to the future. Source: Refinitiv, to 31/12/2008.

Why institutional investors use short selling

Institutional investors have often used short selling to help hedge their portfolios and reduce risk. Alongside long positions, fund managers sometimes take short positions too.

The short positions can be a prediction about what could be next for the company or sector as explained above. But more often, they’re used to soften the blow of an unexpected decline. In this way, short positions can shave some of the profits off a long position, but they also keep the fund from haemorrhaging cash during a downturn.

This strategy became evident during the stock market’s nosedive in March when some fund managers were accused of profiting from the market’s despair.

Bill Ackman was held up as an example of this after reportedly netting $2.6bn from a short position. Ackman was notoriously bearish during emotional interviews in March, leading to questions about his motives. While no one can say for sure whether Ackman was genuine in his interview, the short position that yielded $2.6bn in March was most likely a hedge. He lost a similar amount on long positions, meaning the hedge did its job of sheltering against some downside risk.

The takeaway

Short selling as part of a calculated strategy to minimise risk makes sense for some institutional investors. But as an opportunity to profit from a stock market decline, it falls short.

We think the risks that come with shorting ultimately aren’t worth the potential gains for retail investors – particularly when you take trading fees into account. No one should invest more than they’re willing and able to lose. Short selling can leave you nursing much larger losses than you had expected and even more than you originally invested.

This article is not personal advice. Investments can rise as well as fall in value, so you could get back less than you invest. If you’re not sure if an investment is right for you, please seek advice.

READ MORE

Explore our Investment Times spring 2021 edition for more articles like this.

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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