8 Short selling

Introduction

In 2015, the US$38bn Harvard endowment fund was seeking asset managers with short selling expertise.

If you believe that a company’s share price is going to fall, you have the possibility to profit from it by selling it short.  You borrow the share (there will be a borrowing cost), sell it straightaway and then buy it back when it has fallen to a lower price – provided that it has!  You then return it to the lender, having made a profit from the fall in share price.  If the share price rises, in order to close your position you will have to buy the share back at a higher price and you will suffer a loss.  On the face of it, short selling sounds like a useful proposition.  It contains the attractive possibility to make money in a falling market as well as in a rising market.

You can short an index using a derivative product such as index futures, as well as an individual share.  The volatility of an index is usually less than the volatility of an individual share, and the dynamic of shorting an index is different to that of shorting an individual share.  An individual share price can fall dramatically when market indices are rising.

In the index futures market, discussed below and in the next chapter, for every long position there is an equivalent short position – so a great deal of shorting goes on in the index futures markets!  This chapter is mainly concerned with the shorting of individual shares.

There is no theoretical limit to how high a share price can rise and the short trader or investor can lose more than his original stake or investment.    In a long position, the worst that can happen is that the share price drops to nil. Risk is amplified if the party is trading on margin, i.e., using borrowed money.

A great many investment strategies are long only.  However, there are always some shares that are rising and some that are falling, and market participants are increasingly using long/short strategies.  This makes particular sense when markets are judged to be high.  Shorting is done both tactically and strategically.  Many traders will take a short position as readily as they will take a long position, guided strongly by Technicals.  Traders will often adopt an aggressive approach, buying back […]