What is short selling?

Stocks Sep 15, 2021 / Reading Time: 8 mins
What is short selling?
By Dominic Marino Reading Time: 8 mins

GameStop…

The Big Short….

Billion-dollar bankruptcies….

When we think of short selling, we think of these concepts. It entered the public eye in January this year and became a welcome distraction to a year of COVID and cases. It seemed to be a modern-day Robin Hood narrative – how a group of Reddit trolls broke the internet and took it to Wall Street. You’re thinking, could I do profit from something like this?

Let’s break down what it is short selling, how to do it, and if you should.

The breakdown – what does short selling mean?

Conventional investing is centred around the buying and selling of shares of a company. This ‘share’ gives us part ownership of the company, which we can sell on the market for profit when this part ownership increases in value. Technically speaking, this is having a long position. People will throw around the phrase “buy low, sell high”, as an archetypal mantra of the stock market. Accordingly, ‘long investing’ is markedly more popular because it is better understood, and in line with conventional investing philosophies.

Conversely, when we short sell, we aim to make a profit on a stock when its stock price decreases. Hence, being short on a stock refers to a position that will benefit from a falling asset price, which represents a diametrically opposite position to being long on equity.  Short selling can be profitable, and plenty of fund managers in Australia and abroad utilise a “long-short” investing model to deliver healthy outperformance of the market for their invested clients.

A simple way to explain short-selling mechanics is through a non-financial analogy.

Your friend has just got the brand new PS5 from his local technology retailer. Before he opens it, you ask him to borrow it, to which he obliges.

The next day, you list your friend’s borrowed PS5 for $800 on Gumtree and sell it that day. You’ve now sold a PS5 short and must purchase your friend a new one to return.

The local game store has a console for sale, priced at $825, and you decide to give this opportunity a miss. If you purchased this one, you would make a loss of $25

Instead, you find a listing on a reputable online marketplace for $750. Perfect! You purchase this new PS5 for $750 and return it to your friend, pocketing the difference between the $800 you sold his original console for, and the $750 you just paid for a new one. An easy $50 dollars.

In the stock market, the exact same principles apply. An investor will borrow an asset and sell it on the market, with the intention of repurchasing that asset and returning it to its owner once its price has decreased. The profit from this transaction can be expressed by the following equation:

Profit = (Sale price – repurchase price) – transaction fees

How do I do it?

Determine your asset

Firstly, you need to find a target asset that you believe will decrease from its current price level. This is a critical stage of the short-selling process. Investors can often get confused distinguishing a topping formation (where a security reaches its peak price before it begins a steady downward trend) from a deviation in trend (where a stock decreases slightly before continuing its upward trajectory). Investors use technical and fundamental analysis as tools to mitigate this security selection risk.

Graphs to show the difference between a stock increasing in value and a stock reaching its peak.

Those who subscribe to technical analysis will try to capitalise on the fact that equity markets are dominated by long traders. Accordingly, by identifying trends and trying to put pressure on the market to “create situations where the weaker long investors exit under the fear of losing gains”, they can suppress the share price and undertake short selling.

Fundamental analysis involves scanning information, including negative business earnings, unsuccessful mergers, poor transactional activity, changing management, or shifts in legislation to determine if the market price will fall. This can be difficult because a negative media release might cause a sudden drop in price levels, but that may not be a likely long-term price fall. The price falls can instead be magnified by the triggering of “stop-loss” orders across the market.

Instead, short-sellers should look for repeated negative events that will provide more certainty that a longer-term downward trend is developing – think of the COVID-19 March market frenzy in 2020. Long-term lockdowns decreased transactional activity and enforced bans on international and domestic tourism, creating a perfect long-term catalyst to short aviation-related equities.

Open your position

Once you have picked your security, you now need to contact your broker to request to borrow these shares. The broker then locates another investor who owns these shares and borrows the shares from them promising to return the shares to them. You don’t get to borrow the shares for nothing though. You pay transaction fees for the privilege.

MaqroTrader doesn’t provide short-selling functionality, however, we do provide our clients with access to short ETFs, like BBOZ – the BetaShares Australian Equities Strong Bear Hedge Fund, which allows investors to profit, through positive returns, from a declining Australian market.

Sell your shares

Just like your friend’s PS5, you need to sell these borrowed shares as soon as you can. Remember, you are betting on security to fall in price, but you want to maximise the price you can get currently, to in turn maximise your profit. Transaction costs will be involved in the sale of shares.

Wait and pounce

Play the waiting game and exercise patience. If your technical and or fundamental analysis was accurate, there should be a fall in the market price of shares. Once the price has fallen, repurchase an equal quantity of the borrowed shares at this new level. Return the shares to the brokerage you borrowed them from and keep your profits.

Again, be mindful of associated costs with short selling. Notably, if a company pays a dividend during your short selling period (borrow through the final return), you must pay the full dividend back to the broker when you return the stock because you’re responsible for the cash flow even if you sold it.

A diagram to show how short selling works.

Rules for success

Timing is critical

Short selling is largely predicated on having great timing. Being accurate on what equity will fall, selling at a good time when the price is high or peaking, and then repurchasing when you can get the stock at its cheapest. This is difficult to achieve for a new investor.

Experienced investors will often employ a “mixed short-selling approach”. Once they identify short sale candidates using fundamental analysis, they wait to act until they are signaled to do so through technical indicators or general market movements.

This is because it can take time for the market to recognise “fundamental analysis” changes and price them into securities. Once the market acknowledges that a stock isn’t as strong as its market price suggests, that is when it will fall, and when you can repurchase!

Short selling is for the short-term

On the sell side, there are very few successful “buy and hold” investors. Buy and hold value investing is thus largely exclusive to a “long strategy” on the buy-side. This does not work for short selling because the market expresses inherent upside bias, with a favourability to positive information.

The overwhelming majority of short selling in today’s market is executed by day and swing traders, who look to make modest profits on normal daily and weekly price fluctuations.

Limit transactions to bear markets

Bear markets, a prolonged period of downward trending stock prices, are not as common as you’d think, lasting historically under 18 months and occurring every 3.6 years.

The rest of the time, markets are on an upward trajectory. And often, the market conditions seem to contradict geopolitical conditions that would justify bear markets!

Take the Australian market post COVID: despite enduring lockdowns and our first technical recession since 1991, the ASX-200 grew 58.4% from March 2020 to August 2021, reaching an all-time high of 7628.9 points.

Accordingly, because up to 85% of stock gains are a result of general positive market movements rather than singularly internal corporate fundamentals, it is difficult to short sell during good market periods. Short selling is best isolated to periods of significant downturn and fear because otherwise, you are either swimming against the tide or dampening potential returns (if you pull a short sale off). 

The Short Squeeze is real

Because the market can sometimes defy logic, overpriced companies with atrocious fundamentals that appear to be perfect short-selling targets can often still increase in market price.

This is dangerous because short sales have an expiration date. So, when a stock illogically increases in price, short-sellers must act fast and exit their positions. However, because short-sellers ‘exit’ their positions with buy orders, a greater number of buy orders pushes the price higher. This rise in price also attracts new market participants who purchase, further driving a rapid upward growth trajectory that becomes a cycle – a classic “short squeeze”

A critical key to success is to not short stocks with squeezable characteristics – A high “short-interest” ratio, low daily trading volumes and strong bullish sentiment still surrounding the stock induce short squeezes. The aim is to limit unexpected price increases as much as possible. Equally so, it’s best to avoid shorting stocks that have a highly loyal and sticky customer base.

Too good to be true?

For conventional investors looking to earn a greater return than the rates we earn leaving cash in banks, should we short sell? Probably not.

Short selling made headlines through the GameStop debacle, where thus far, shorter sellers have lost approximately $19 billion in funds (since Jan 2021).

Tesla short-sellers lost even more in 2020, trying to capitalise on the uncertainty of electric vehicles and Tesla’s overpriced market valuation. This group lost $40 billion collectively. At the start of 2020, short-sellers held 16% of shares, compared to 6% at the start of 2021.

The real danger of short selling is that your downside is unlimited. In the case your borrowed stock increases in value after you sell it, you now face a loss which is determined by how far the share price increases, and the number of shares you borrowed. Short selling is thus highly risky and speculative.

Looking at the past 2 years, one UBS financial advisor recommend a short-selling strategy to his investors, who lost a collective $23 million after being recommended to “hold the position”. In 2020, $700,000 was awarded to an investor after a Morgan Stanley advisor recommended a short sale on Amazon (AMZN) in the US.

Short selling can also be seen as a bit of a ‘grubby’ investing tactic, profiting from the downfall of companies and livelihoods. The former head of the New York Stock Exchange described it as “icky and un-American”. Napoleon considered shorters in the 1600s tulip bubble to be “treasonous”. However, it is now being seen as an important component of a liquid and efficient financial market. Short-selling bans across major financial crises in Australia, Belgium, Canada, Germany, Japan, South Korea, the UK, and the USA have rapidly fallen from the 2008 GFC to the 2020 COVID-19 downturn. Irrespective, some consider it unethical.

Column graph showing short-selling bans
Source: AIMA, May 2020

Warren Buffet, considered by many to be one of the great investment thinkers, doesn’t short. Buffet recognises short-selling temptations because an investor “will see more stocks that are dramatically overvalued than dramatically undervalued”. However, he says this – “in my experience, it is a whole lot easier to make money on the long side”, professing the “painful” nature of short selling.

At Maqro, we stick to delivering our clients great returns through a data-driven prudent, and well-informed investment research framework.