INVESTING EXPLAINED: What you need to know about short selling – a trading strategy that aims to profit from a falling stock price
In this series, we break the jargon and explain a popular investing term or topic. Here is the short sale.
What is that?
Trading strategy that aims to take advantage of a fall in the price of a stock, bond, commodity, currency or stock index. It’s risky, potentially lucrative. US short sellers lost $572 billion between 2019 and 2021, according to analyst group S3 Partners. But in 2022, they made profits of around $300 billion, after betting that stocks such as electric vehicle maker Tesla would fall.
How it works?
An investor convinced that the shares of a company are destined for a sharp decline borrows a parcel of those shares from an existing holder, such as a fund. The trader sells stocks, hoping that they will fall. The next step is to buy them back later at a reduced price, to return them to the owner. The profit comes from the difference between the price at which the shares were sold and the price at which they were bought back.
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What can go wrong?
A lot. The direction of stock prices can confuse even the most seasoned investor. Technically, a short seller’s losses can be unlimited because, in theory, a stock can continue to rise and there is no cap on how much you might have to pay to redeem the stock. When the price of a stock rises unexpectedly, short sellers can get caught in what is known as a “bear squeeze”.
Is this new?
It has been around since stock trading began in the 1600s in the Netherlands. It has been banned several times. “Naked” short selling – selling shares short without borrowing them first – is illegal in the US and UK under rules adopted by the EU. The whole short-selling regime is to be changed as part of the Chancellor’s proposed Edinburgh reforms for the financial services sector, which are under consultation.
Is short selling a bad thing?
Views differ. Some claim that short selling is a key part of an effective stock market because it enables “price discovery” – revealing the true value of a stock.
But short sellers are also accused of driving down a stock’s price or making it worse, sometimes turning into a rout. They are also sometimes said to take advantage of misfortune.
Which stocks are sold short?
The list of stocks, compiled by the Financial Conduct Authority, includes Asos, Kingfisher, Boohoo, Hammerson and Currys. Investors should consult this list regularly.
Why would a fund lend shares?
For fees. Institutions around the world earned $12.5 billion in revenue from such loans, according to S&P Global Market Intelligence. During the pension crisis, triggered by last year’s mini-budget, some investors shorted government stocks as the prices of those bonds fell. Institutions lending to these short sellers earned some $182.4 million.
Who are the big shorts?
The most famous is Michael Burry, founder of Scion Capital, whose bets in the US subprime mortgage market before the global financial crisis were chronicled in Michael Lewis’s The Big Short, which was later made into a film. Anyone interested in Burry’s views on today’s scene should follow him on Twitter (where he uses the name Cassandra BC). Other players include Carson Block of Muddy Waters Research.