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Short Selling

What Is Short Selling?

The practice of short selling (also known as shorting or going short) is when traders sell an asset without owning it on the hope or expectation that its price will fall and they can buy it back for a lower cost to make a profit. If the price rises, the trader would suffer a loss when they subsequently buy back.

In a typical short sale, traders will borrow securities from a third party, usually their broker, in order to sell, and then buy them back to return them to the lender. The lender technically maintains ownership of the shares throughout the transaction. Short selling without having possession of the asset to be traded is called "naked" short selling and is generally prohibited. Naked short selling is a practice that could be used, theoretically, to artificially depress the price of an asset.[1]

History Of Short Selling

The origins of short selling can be traced back into antiquity, when traders negotiated contracts for grains and other commodities before they were harvested. The first documented effort of the short selling of securities in organised financial markets dates to 1608, when Dutch businessman Isaac Le Maire sold shares of the Dutch East India Company short in order to make a profit.[2]

Le Maire and some of his partners were reported to have spread rumors about the poor performance of the company so that its share price would fall. The company lodged a complaint and the government ordered a partial ban on short selling. Le Maire was barred from accessing his shares and lost substantial money on the deal.[2]

Despite that, the practice of short selling prospered and spread over the centuries. In the 1930s, with the notion that short selling brought downward pressure on prices, the U.S government attempted to regulate the practice with the "uptick rule" by limiting it to periods of upward price movements. In 2007, the government lifted the rule, but in 2010 it partially re-introduced it by barring short selling during market declines of 10% or more.[3]

Improving Liquidity

Proponents of short selling say that not only can the practice be profitable, but that it is also an important element for helping maintain liquidity in the market. With short selling, they note, potential buyers have a greater guarantee of having sellers available to deliver an asset when they are seeking it.[4]

Margin Accounts

A trader who wants to practice short selling will need to open a margin account. A margin account is a deposit of funds with the trader's broker to cover losses posted by the trader. A debit to a margin account to cover a loss is called a "margin call." In some cases, if traders holding both long and short positions incur losses on their short positions, brokers can liquidate the long positions to cover margin calls.[5] Trading on margin carries a high level of risk as losses can exceed deposited funds.

Risks Involved With Short Selling

Short selling is a common practice among institutional investors, such as hedge funds, and also of wealthy individual investors who have available capital to put at risk. With the practice, they're able to learn when markets or the price of individual assets are rising, and also when they are falling.

Many investors will use short selling as a hedge to offset declines and avoid taking large losses in downward trending markets. While the practice can be a good way to maintain gains in any market conditions, it's not without risk.

Special caution is recommended in preparing to take short positions and executing such trades. Small-scale or novice investors may be particularly at risk because they may not have the capital or the technical instruments available to assure that the trades can be carried out without incurring a steep loss.

The main risk involved with short-selling is that the price of the asset chosen to sell may rise instead of falling, making the seller liable to replace it for the lender at a higher cost. The maximum profit for a short sale with a declining asset price is limited to the difference between the selling price and the price at which the asset is borrowed. However, theoretically, the risk when the price rises is unlimited.

There have been instances where sellers who were caught out on trades that went in the wrong direction were then forced to pay back several times the amount of the profits that they were hoping to make on expected price declines.[6]

Other Considerations: Interest And Recalls

When borrowing an asset to sell, a trader may be required pay interest on the loan. If the asset is scarce because of higher demand, the interest rate paid on the loan will rise. Also, if the asset pays dividends or interest, they must be paid to the original owner of the asset. An additional risk to short selling, especially with stocks, is that the lender of shares may have the right to recall them at any time. This forces the seller to find another source of shares to back the transaction.[7]

Short Selling With Options

One popular way to limit risk in short selling is to trade in options markets using puts. Options contracts allow buyers the right, but not the obligation, to buy or sell a given security at a particular price.

Options come in calls and puts:

  • A call gives a buyer the right to buy a security at a particular price.
  • A put gives a seller the right to sell a security at a given price at a date in the future.

In a typical put option trade, a trader might acquire a put option for given asset with a strike price of US$20. If the asset is trading on the market for US$15, the trader can buy it at that price and will have the right to deliver it at the contract expiration to the seller of the put at the agreed-upon strike price. The trader then pockets the difference. However, traders will typically exit winning or losing put positions earlier and will not hold on to them through the contract expiration.

Another manner to use options for short selling is a "naked" call. With a naked call, traders can sell the right to buy an asset at a price in the future without yet owning the underlying instrument. Unlike pure naked short selling, the use of naked call options is permitted. But like naked short selling, they can provoke severe losses if the stock price rises significantly above the strike price.

Short Selling Currency

Unlike in other markets, short-selling in currency markets can be simpler because no outside borrowing is required. However, traders will have to cover for any losses that might occur on a trade.

Currencies are typically bought and sold in pairs with the first part of a price quote being the base currency and the second being the counter currency. In a sample short-sale, you could sell GBP/USD at 1.40. In this transaction you are selling pounds and buying dollars. If the price of the pound moves to 1.25 against the dollar, you could buy the same pair back, and earn a profit on the difference in the price. However if the price rises to 1.65 against the dollar, when you buy the same pair back you would suffer a loss on the difference in the price.

Summary

Short selling is a technique for trading down-trending prices and potentially making a profit even when there is bearish sentiment about a particular asset or market. It has been used for centuries, particularly among large-scale traders, to hedge against downward movements in prices. While short selling can be executed with success, it is not without risks. If the price rises, traders could suffer a loss which can exceed their original investment. Traders should be prepared to set aside margin funding to cover possible losses and monitor for prices that may move unexpectedly against the planned trade.

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