Short-selling has been in the news in 2021 thanks to the GameStop Corp (NYSE:GME) saga. Retail investors, urged on by users of the subreddit r/wallstreetbets, drove the share price to dramatic highs, initiating a squeeze on short sellers. This resulted in major losses for some short sellers, and ultimately, some long investors too, as the share price has now returned to more “normal” levels.
So now that the drama has subsided, let’s take a look at short-selling. Short selling is a trading strategy that speculates on a decline in the price of an asset. Short-sellers, in essence, are making a bet that the price of a share will go down. This is the opposite of long investors, who buy shares in the hope prices will increase.
People can sell a share short for a number of reasons. It may be to speculate, to hedge a position, to protect gains or to mitigate losses in a security or portfolio. The short seller makes a profit when the price of a share falls, so can make profits in a declining or neutral market. But when the share price rises, the short seller is in trouble, as the GameStop saga showed.
How does a short sale work?
In order to short sell shares, an investor borrows shares with a promise to give the same number of shares back at a future date. The short seller then sells the shares into the market. When the date comes to return the shares to the lender, the short seller must buy them back in the market. If the share price has fallen in the interim, the short seller makes a profit.
Let’s take an example. Say you thought Afterpay Ltd (ASX:APT) was overvalued at $120 a share and that the price was going to drop. So you decide you are going to short sell it. You contact your broker and tell them you want to borrow 10 Afterpay shares. Then you sell these on-market for $1200. If the Afterpay share price decreases to $50, you will only have to pay $500 to buy back the shares to return to your broker, netting you $700 (minus the costs of the transaction). But if the price of Afterpay shares increases to $200 you will need to pay $2000 to buy them back. You’ll be out of pocket $800 plus the costs of the transaction.
What are the risks of short selling?
Short selling is risky – there is theoretically no limit on how high a share price can go between when a short seller sells a share and when they have to buy it back. The short seller’s potential gains are capped, because the share price can’t fall below zero. But their losses are potentially unlimited, driven by rises in the share price. A small bet could end up costing much more than expected.
When you buy a share (go long) the most you are risking is the amount you spent on that share. Your gains from going long on shares are potentially unlimited as the share price can continue to increase. When you short a share, the opposite is the case – your potential gains are limited and your potential losses are unlimited. Because of this imbalance in potential outcomes, short selling is not commonly used by retail investors.
There are also costs involved in short selling. Short positions are generally purchased using some type of margin loan, which involves interest charges. If the price of the share you have short sold goes up, you can get a “margin call”. This means you need to contribute additional capital to maintain your minimum investment. If you can’t provide this capital, your broker could close out your position at a loss to you.
Why do people short sell?
Short-selling can be used by speculators looking to capitalise on share price declines. It can also be used for hedging, an investment strategy used to reduce the risk of adverse price movements in an asset. Hedging involves taking an offsetting position in a related security, for example, taking a long position in certain shares and offsetting this with a short position in the same or other shares. Short selling is a strategy mainly employed by professional or institutional investors rather than retail investors. This is because of the costs and risks involved.
Should I short sell?
Short-selling is generally not recommended for retail investors because of the risks involved and limited upside potential. Even when a share is performing badly and looks certain to fall in price, there are numerous factors that can cause the price to rise instead. For example, the general market could rally, the company could become a takeover candidate, or unexpected good news could be announced. Or, potentially, a reddit forum could drive the share price to new levels. Short selling is a high risk/reward strategy which can be profitable, but can also result in substantial losses if the market moves against you.
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