What is Short Selling?

Short selling, also known as shorting a stock, is a trading technique in which a trader attempts to generate profits by predicting a stock’s price decline. While the technique is commonly used to short stocks, it can also be applied to other securities, such as bonds and currencies.

Within the context of a stock, short selling is a bet by the trader that the stock’s price will fall in the future due to multiple reasons, from flawed business models to falsified accounts. The trader is rewarded with profits, if the predicted decline occurs. If the expected event does not happen, the trader loses money. Shorting can generate exponential returns for successful trades. But it can also result in massive losses for shorts that are on the wrong side of a trade.

Short selling is considered a controversial activity because it can distort prices and markets for a given security. It has been banned several times in the past in financial markets. In recent times, active investors and short sellers have contended that the growth of passive investing products, such as ETFs, has contributed to a decline in short selling’s popularity.

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How Is a Stock Shorted?

To short a stock, the trader borrows shares of the company from a broker-dealer and sells them in the open market. Cash from the sale is returned to the lender. If the stock’s price declines in the future, then the trader buys the stock back at the lowered price and returns the borrowed number of shares back to the broker-dealer, keeping the profit to himself.

A trader can short a stock indefinitely, meaning there is no time frame associated with shorting a stock. But the broker-dealer responsible for lending the shares has the right to “call” the stock or ask for it back. In such instances, the trader is obligated to return the stock by purchasing it in the open market at the prevailing price. A variation of short selling is naked selling in which the trader sells shares without borrowing them first. It was banned after the 2008 financial crisis.

As an example, consider the following case of short selling. The shares of company ABC are trading at $100 per share in the open market. Joe shorts the stock, betting that the company’s shares will decline to $50. He borrows 100 shares of ABC from a broker-dealer and sells them in the open market for $10,000. Three months after Joe’s bet, a massive accounting irregularity is discovered in ABC’s books and its share price falls to $50. Joe immediately purchases 100 shares of ABC for $5,000 and returns them to the broker-dealer, pocketing the $5,000 profit from his short.

However, Joe’s losses would have multiplied if ABC’s share price had increased. Suppose ABC’s share price skyrocketed to $200 in the next two years and his dealer wants the shares back. Joe will have to pony up $20,000 to buy 100 shares of ABC at the current price. In the process, he loses $10,000 of his own money in the process.

Besides being a mechanism for profit making, short selling also serves other purposes for traders. It acts as a hedge against long positions they may have on a stock. For example, if Joe is long ABC, he might also hedge his holdings with an equivalent or comparable short in order to cover his losses if the ABC’s price fails to appreciate. This way he is managing risk on both sides.

The Financial Equation Behind a Short

The short seller should have a margin account with the trading firm to cover the costs of their trade. The Federal Reserve Board’s Regulation T defines margin requirements at fifty percent of the trade while the NYSE requires thirty percent of market value at the time of the trade.

The shares borrowed may not necessarily be owned by a lender or from her own inventory. The lender may source them from another client’s security holdings (with the client’s permission). The proceeds from a stock’s initial sale are deposited with the lender along with collateral. Generally, lenders ask for 102% of the trade cost, also referred to as a loan, in collateral. The loan is mark-to-market, meaning its value changes with the security’s daily market value. An increase in the security’s price will necessitate more collateral. The collateral itself is invested to generate returns at market interest rates, a part of which is shared with the borrower at a predetermined rebate rate. The lender fee is the spread between these two rates.

Short Squeezes

Short squeezes occur when a trader purchases a large block of shares to finish a short position. The purchase could result in artificial demand for a company’s shares and result in a temporary price bump for the security. Because the security’s price increase occurs without regard to its fundamentals, it is destined to a future decline and is termed a “short squeeze” because it inflates the price for a brief period of time.

One of the most famous short squeezes in history occurred in 2008. German carmaker Porsche owned approximately 31% of Volkswagen in March 2007 and Lower Saxony, a state in Germany, owned 20 percent. Porsche used Volkswagen’s factories to manufacture its cars and had stated publicly that it did not intend to pursue a takeover.

When the financial crisis hit in 2008, hedge funds and speculators took up short positions amounting to roughly 13 percent of Volkswagen’s total publicly-traded stock. The move sent its stock price tumbling. In October that year, Porsche told investors that it owned approximately 74 percent of the company through direct ownership and call options on its stock. Hedge funds who had bet against Volkswagen panicked because it meant that they would find it difficult to cover their short positions, if it succeeded. Lower Saxony and Porsche, who together owned more than 90 percent of the company, would not be willing to sell their positions. The demand for Volkswagen’s shares was such that the company’s share price skyrocketed to 1,005 euros from 200 euros a few days earlier. The car maker even became the world’s most valuable company briefly and an analyst termed Porsche’s move “the mother of all short squeezes.”

Impact of Short Selling on the Stock Market

Short selling is essentially a speculative activity. As such, it has a mixed effect on the market. Depending on the scale and nature of the short, it has the potential to magnify losses, playing havoc with natural price discovery occurring in the markets. Critics of short selling contend that it exacerbates downward price movements, heightens volatility, and causes an exodus of investors from the security being shorted.

During the 1997 Asian financial crisis, investor George Soros was accused by the Malaysian government of “massive currency speculation” because he shorted the Thai Baht and caused the crisis. Short selling was also blamed for the 1929 and 1987 stock market crashes. During the financial crisis, the SEC imposed an emergency ban on short selling in September 2008.

Prominent defenders of short selling include activist investors and firms. For example, Seth Klarman, a hedge fund billionaire who runs Baupost, an investment group, says that short selling is necessary to counter bull markets. Warren Buffett has made the case that short selling helps uncover fraud and false accounting in company balance sheets. Research released by the World Federation of Exchanges claims that short selling bans are harmful to stock markets because they reduce “liquidity, increase price inefficiency and hamper price discovery.”

In recent times, however, the effect of short selling on investment markets has been tamped down due to the rise of passive investing. Pension funds and large institutional investors invest in stocks for the long-term and are averse to short sellers. Vehicles for passive investing, such as exchange-traded funds, guarantee safer bets through fixed returns and fewer losses. They have also taken large holdings in companies to minimize the overall effect of active investors and short sellers in a company’s share price.