Short selling

Definition

Short selling is a trading strategy used in financial markets where an investor, typically believing that the price of a particular asset will decline, borrows that asset (often stocks) from a broker and sells it on the open market.

What is short selling?

The goal of this strategy is to buy back the asset at a lower price, return it to the broker, and pocket the difference as profit. Here are some key points about short selling:

1. Borrowing the asset:
   • The investor borrows the asset from a broker, often paying a fee for this borrowing arrangement.
2. Selling on the market:
   • After borrowing, the investor immediately sells the asset in the stock market.
3. Profit from price decline:
   • The investor hopes that the price of the asset will decrease. If it does, they can buy it back at a lower price later.
4. Buying back and returning:
   • Once the price has fallen to the desired level, the investor repurchases the asset in the market. This is known as “covering” the short position.
5. Return to broker:
   • The investor returns the asset to the broker, effectively closing the short position.
6. Potential for losses:
   • Short selling can be risky because if the price of the asset rises instead of falling, the investor may incur losses. In theory, there’s no limit to how high the price can go.
7. Margin requirements:
   • Brokers often require investors to maintain a certain level of funds in their account (known as margin) to cover potential losses.
8. Regulatory oversight:
   • Short selling is regulated by financial authorities to prevent abusive or manipulative practices.
9. Market efficiency:
   • Some argue that short selling contributes to market efficiency by providing a mechanism to express negative opinions about an asset.
10. Controversy:
    • Short selling can be a contentious practice, especially when it involves heavily shorted stocks or in cases where it’s perceived as contributing to market volatility.
11. Hedging strategies:
    • Some investors use short selling as a way to hedge their portfolios, providing a way to potentially profit from market downturns.
12. Time constraints:
    • Short sellers must be mindful of time constraints, as the longer they hold the short position, the more they may have to pay in borrowing fees.

Short selling is a complex and potentially high-risk strategy that requires a deep understanding of the market and the specific assets being traded. It’s important for investors to carefully consider the potential risks and rewards before engaging in short selling.

Example of short selling

Let’s say Investor A believes that the stock of Company XYZ is overvalued and expects its price to decline in the near future.

1. Borrowing the stock: Investor A contacts their broker and borrows 100 shares of Company XYZ from the broker.
2. Selling the stock: Investor A immediately sells the 100 shares of Company XYZ on the stock market at the current market price of £50 per share, for a total of £5,000.
3. Waiting for the price to decline: Investor A waits for the price of Company XYZ’s stock to decline, as they anticipate.
4. Buying back the stock: Suppose Company XYZ’s stock price indeed declines to £40 per share. At this point, Investor A decides to buy back the 100 shares to return them to the broker.
5. Returning the borrowed stock: Investor A purchases 100 shares of Company XYZ at £40 per share, spending £4,000 in total.
6. Profit calculation: Investor A returns the 100 shares to the broker, profiting from the difference between the selling price and the buying price.
   • Selling price: £5,000
   • Buying price: £4,000
   • Profit: £5,000 – £4,000 = £1,000

In this example, Investor A has successfully profited from short selling by selling high and buying low.