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Who’s afraid of short selling? Everything you need to know about “going short”

10:00, 4 March 2022

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Short selling ought to be a key tool in any trader’s box. Trading is all about taking a view, and “going short” is simply an expression of a particular view, that the price of a security will fall in the near term.

 

So “shorting” ought to be a key tool for traders. But, too often, it isn’t.

Why not? There are probably two reasons: one related to the alleged difficulties of going short, and the other connected with the practice’s poor public image.

Bridging the gap

To take the first point, short selling is often shrouded in the sort of mystique that leads one to suspect that its practitioners are seeking to scare away novices while building up their own image as seasoned professionals.

Let’s take the mystique away. Short selling is an expression that derives from the very simple notion of being “short” of a security, such as a stock. Someone is short either because they have sold the stock in question or because they never bought it in the first place.

It is, rather obviously, the exact opposite of a long position, one in which a stock is either acquired or retained.

Short selling takes this notion and turns it into a strategy. Again, at its simplest, it involves selling at today’s price a stock whose value the trader expects to fall and which the trader has yet to own – filling the order at an expectedly lower future price.

There is, by definition, a gap between the sale and the delivery of the stock to the buyer, given that the whole point of “shorting” is that the seller buys the security in question at a future lower price. In years gone by, the lengthy “account periods” of perhaps two weeks would give the short seller a breathing space in which to pick up the now-cheaper stock.

But a long-running trend towards “real-time settlement”, a high-tech version of cash on delivery, has shrunk settlement times, prompting the increased use of “stock borrowing” to bridge the gap.

Stock borrowing (or the borrowing of whatever security is being shorted) is arranged through a broker. The broker lends the trader the securities to sell at their current price, but the trader does not pay for them until their position is “closed”, in other words the trade in question has either “come good”, or not.

“Bear traps”

You may wonder why the broker is happy to provide this very useful service to the short seller. The reason is simple: because the short seller has to pay the broker commission and interest on the loan of the shares, and the broker receives these payments regardless of whether the short-seller’s trade works out or not.

These overheads are part of the cost of short selling. A far bigger potential price arises when the short seller has simply made the wrong call and gone short on a security whose value is rising.

In such a situation, the short seller will be faced with paying for the securities at a higher price than that for which they were sold, incurring a loss. The buyer, by contrast, will be showing a profit on the original sale, as the purchase price is now below the market value.

How can a short seller find themselves in this position? Most of the time, simply because they misread the likely performance of the stock or other security, taking an unduly pessimistic view of its prospects and being proved wrong.

Remember that for every seller there is a buyer, and there is no guarantee that the original purchaser is mistaken in seeing a good deal in buying at the current price.

Sometimes, the short-seller’s original analysis was correct but has been falsified by subsequent events that could not possibly have been foreseen. An obvious example would be a mining company whose prospects by any measure looked poor but which has stunned the market by announcing a major gold find.

And sometimes, the short seller’s strategy comes to grief because of deliberate action to teach short sellers a lesson. This can be action by the issuer of the security in question, such as a company, or in the case of currency trading, by a central bank – in days gone by, the Bank of England would try to “burn the speculators’ fingers” with surprise action, such as buying sterling in the market or putting up interest rates.

Such actions come under the heading of a “bear trap”, and when such traps are successfully sprung, there is much satisfaction by the trappers at the discomfort of the short sellers.

Bans in the US and Europe

This takes us neatly to the second factor that can discourage novice traders from short selling: its reputation as a barely legitimate activity that has nothing to do with the “proper” business of trading and investment.

Whenever a company’s stock falls, you will read in the financial pages that “aggressive short selling” is to blame. Much the same is true of sharp declines in commodity prices and bonds.

Traditionally, this line of attack has been seen in its most concentrated form in currency markets, when heavy selling of a particular denomination is ascribed to short selling. Indeed, a myth has circulating for many years that “no-one ever lost by running against a central bank”.

This is the heart of the claim that short selling is some sort of market abuse, almost akin to insider dealing. It is a widespread view that, since the financial crisis, has seen bans imposed on shorting on both sides of the Atlantic.

But it is entirely mistaken. True, in the foreign exchanges, short sellers like to bet against a currency that is pegged to another currency, when the first currency is weakening, although even then there is no guarantee that they will be successful.

Even when they do profit from the weaker currency, the answer is not to ban short selling but to avoid currency pegs, as Britain has done since the “Black Wednesday” debacle of 1992.

Yes, short selling is often a purely speculative strategy. But it can be used also to hedge a long position, offsetting some of the risks of the holding in question.

In summary, short sellers can, and do, find themselves on the wrong side of a trade. Short selling is no more disreputable than “long buying”.

Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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