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What is Short Selling?

Posted By Robert On Friday, December 20th, 2013 With 0 Comments

Short selling is a way to make money by betting a company’s share price will fall in value. You can also profit from downwards movement in commodities, stock indices or currency pairs. Let’s suppose that you short Gulf Keystone (GKP) at 90p and it drops to 80p, you’ve made an 11% profit. This may sound simple but you can potentially lose am amount greater than your initial deposit.

How To Make Money When Share Prices Fall

Incredibly, while most private investors will be happy to buy stocks and shares, they traditionally have remained oblivious to the opportunities that exist when markets move lower and in the current volatility, this could mean losing out.

Short selling is simply the placing of bets that the price of an asset, commonly a share, will fall although in practice you can also profit from downwards price movements in commodities, stock indices or currencies.

Short selling often sounds complicated and most people think that it is something that only hedge fund managers and city high flyers can do. However, the purpose of this article is to show that it is in fact fairly easy for anyone to profit from a stock or share decreasing in price. It may be best to use different ways of shorting equities than institutional investors, but it is still very possible. This means private investors can make money even if share prices are falling.

The Theory

When short selling someone (person A) borrows the shares from someone else (person B). Person B may be a hedge fund, or a large institution who is willing to lend their shares, generally for a fee, and enters into an agreement to have them returned on a certain date.

Once person A has been lent the shares they sell them at the current market price, say 10 shares worth £1 each, so they get £10. As person A expected, the shares decrease in value and so on the day that he gives them back to person B, he buys 10 shares back at £0.80 a share, therefore costing him £8. He gives the shares back to person B, and pockets the £2 profit that he has made.

Let’s suppose a hedge fund wishes to sell short Tesco shares. The trader borrows shares in the supermarket chain from a party who owns it, like a pension fund for instance, and sells it in the market. The hedge funds will do this in the expectation that the Tesco stock price will fall before they have to buy back the Tesco shares and hand them back to the original owner, netting the difference in value.

But why would a pension funds lend its shares to a short seller? It may appear absurd at first to lend anyone shares for them to profit from your potential loss but the short seller has to pay any upcoming dividends, plus a fee for borrowing the shares, a bit like interest on a cash loan. This lending provides a way for managers of index, ETF and institutional funds to earn additional revenues and fees can be substantial particularly when there is limited shares available to borrow. The prime broking departments of banksn are centre to this process; they find stock which hedge funds can borrow and lend them securities to trade with.

This is a slightly over simplified version, as there other costs associated, such as dealing costs and the fees to borrow the shares, but this is essentially the theory behind short selling.

Short selling is an area to which investors can look to profit from during market turbulence or bear markets. Short selling allows you to profit from falling prices such as shares, indices, currencies or commodities. You can short sell the markets through financial spread betting or CFD trading.

CFDs

One way that private investors can make money on a falling share price is through a Contract For Difference or CFD. A CFD is an agreement between two people or organisations to pay the difference between the value of an asset at the start of the contract and the value of an asset at a specified and agreed end data.

Typically there is a buyer and a seller, if the asset increases in value, the buyer pays the seller the difference, and if the asset decreases the seller pays the buyer the difference. There is no need for anyone to own the asset, instead it is just a contract between two people speculating on the future price of an asset.

CFDs are banned in some countries, including the USA and so this option is not available to everyone.

Spread Betting

Another way to profit from a decrease in the price of an asset is through spread betting. This is a simple bet on the value of an asset and can be leveraged. This means that you could bet £1 per point that it increases or decreases, or £10. The more you bet, the more you can win, but also the more you can lose, and you can also lose more than you initially bet.

The fee you pay is included in the spread – the difference between the buy and sell price of the asset, as well as a charge levied on holding the asset over a period of time, usually calculated daily.

Choosing The Shares to Short

This is by far the most difficult part of short selling assets, choosing which shares you think will decrease in value. There are an infinite number of reasons that may cause prices to fall, such as macroeconomic problems leading to a fall in the market in general, to profit warnings, long term declines in an industry, debt issues and many more.

The key is to do your own research before you make a decision. There are many ways to research companies, visit the company’s website, or a range of other websites offering information on listed companies. However the key is to do your own research and only treat what other people say as ideas for further research.

What is Short Interest

This refers to the amount of stock that has been borrowed by traders and institutions, expressed as a percentage of a company’s total market capitalisation. Another key figure to keep an eye on is the proportion of ‘borrowable’ stock that is currently lent.

Disclosure

An European Union directive passed in the aftermath of the financial crisis makes it obligatory for parties to inform national regulators when they take out a short position worth more than 0.2% of a company. Note that since 2012, traders and investors are obliged by law to inform the authorities whenever they take net short positions which amount to more than 0.2% of a company’s shares and the regulator then makes this disclosure public if the total positions amounts to more than 0.5%.

The disclosure paperwork doesn’t require one to disclose the ultimate beneficiary of the short position (if the positions are taken in the name of a third party corporate entity).

Why would short sellers want to be anonymous?

Some parties, particularly hedge funds don’t like to be named in public. This is for a number of reasons, not least that famous short sellers can be a target for executives of a company whose shares are taking a beating. Also, disclosure will attract attention which can make it harder to borrow stock needed to build up a large short position as others copy the trade. The cost of borrowing the shares also increases if many investors want to take the same position.

Is Shorting morally wrong?

Some buy-and-hold investors frown upon short sellers because they believe it is just a way to release malicious rumours or gang up on vulnerable companies and force their stock price further down causing financial losses to shareholders. But shorting can also be an effective way to hedge long positions or profit from companies that are overvalued or have released negative figures. Shorting is needed for efficient markets. And really with the same premise why is it not okay to short but okay for a group of analysts to talk up a stock as they will profit from more people buying the shares??

Conclusion

So it is very possible in theory to profit from a decrease in the price of an asset, but knowing which assets to short is the hardest part. Before making any decision, make sure you read up on how to invest and understand all the terminology so that you can make the best decisions possible about any asset you think is going to decrease in value. Assets can be affected by both fundamental and technical factors, so ensure you research both.

Of course, like any financial product, retail traders should not deal in spread betting or CFDs or other complex instruments unless they understand their nature and the extent of your their exposure to risk. However, if you are satisfied that the product is suitable for you in the light of your circumstances and financial position, then it can be a viable way of making gains or protecting positions elsewhere.

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