Shorting Stocks

Shorting Stocks (Short Selling)

What exactly is short selling?

You may have often heard about traders being long or short a stock or advising to short a particular sector. In a traditional equity investment where the investor purchases stock hoping for the price to rise he or she is said to have a long position. A short position is simply the opposite of this. To go short a particular stock, the investors sells a stock that they do not yet own, hoping that prices fall so that they can buy it back later at a later price.

In esence then shorting a share is betting that the price will fall in the future. Selling a stock you do not own may be a strange concept however this is achieved by borrowing the stocks from your broker, allowing you to sell them to the market at the current price. Assuming the price does fall you can then buy the stock in the market at a cheaper price and give it back to the broker that lent you the original stock, having made a tidy profit along the way.

Why do you want to short stocks?

Speculation is one reason why stocks are shorted. Hedge funds are the classic stock shorters. If you believe that the prospects of a stock look bleak and are convinced from your analysis that the share price will fall you can profit from any downturn in the share price by shorting the stock.

In volume terms the most popular reason that short positions are used is to hedge against long positions. Hedging simply means reducing or eliminating risk. Assuming you have a long position in a particular stock and some recent bad news has questioned the long term potential for future growth. If you are not bearish enough to sell the stock in question you could take out a short position iin the stock to reduce or remove any potential losses that may result in a fall in the share price.

Drawbacks of shorting stocks

One of the main restrictions of short selling are the associated costs. Firstly you will have to pay your broker a fee to borrow the stock that you will be shorting. This is usually done via a margin call. In addition you may only be able to borrow certain stocks (usually just those on the main exchanges) and only in certain quantities which are usually large and round numbers. This means that you may not be able to fully hedge your long positions.

Historically equities prices maintain an upward momentum therefore by shorting a stock you are betting against the long term trend in the equities markets.

When stocks rise in price they tend to do so in a slow and steady fashion however when stock prices fall they tend to do so rapidly. This inherently means that short selling is riskier and more volatile than purchasing stock. In addition your potential losses can be infinie as the value of a company can theoretically keep rising whereas in a long position you can only lose the value of your initial investment in the stock as the price can only fall as far as zero.

If a stock rises in value and there are lots of short investors suddenly trying to re-hedge their positions by buying stock this can have the affect of pushing the stock price higher. This then turns into a self fulfilling cycle with all of the short sellers pushing up demand and (the price) of the stock they are short.

Summary

Short selling opens up the possibilities of profiting from a decline in prices to investors that have traditionally only had the chance of losing money in a bear market. Along with this great opportunity to the investor comes a new basket of risks such as margin calls, price rises and betting against the market trends.