What is Short Selling?

Selling a stock that you do not own!

What is short selling or selling short? Shorting stocks involves the selling of stock that the seller does not own.

This could include stock that the seller has borrowed from a stock broker, from a superannuation fund, or from some other source.

Selling short not only applies to stocks. Shorting funds and shorting futures contracts are just two examples of shorting different securities.

Carefully regulated, selling short is generally regarded as a quick way to find the 'real price' of stocks ... that is, it aids price discovery.

Why Sell Short?

People who sell short have a view that the market is about to retreat, so by selling short they hope to profit from the downturn.

People who sell short make money if the stock goes down in price rather than going up. 'Selling short' is the opposite of 'going long'; that is, buying in the conventional manner.

Short sellers then hope to buy the stock at a lower price than that at which they sold short in order to cover the initial sale.

Naked Short Selling

Illegal naked shorting is the practice of shorting stock that has not been borrowed, or determined that it can be borrowed, before it is sold short.

But due to various loopholes in the rules and trading discrepancies, naked shorting continues to happen.

Naked shorting is illegal because it provides shorting opportunities for manipulators to force stock prices down without regard for normal stock supply and demand patterns.

Risks of Short Selling

Selling short is in some respects a speculative strategy with unique risks and pitfalls. A short sale appears to be the opposite of a regular buy transaction, but the risks are different.

For instance, over time the stock market has an upward movement, helped in part by inflation. Selling short is betting against the long-term direction of the market.

When you buy long, that is, in the conventional manner, the most you can lose is all the money you invested. Not a pleasant thought!

But when you buy short, if the market rises and other short sellers are forced to buy to cover their positions, the price is likely to rise further. This phenomenon is known as a short squeeze.

If you are not nimble enough, or are not around to buy to cover your position, you could lose more than what you invested if the price continues to go up.

Another unique risk is one that could apply to value investors. You may have calculated that a stock is seriously overvalued and decide to short it.

Even though a company is overvalued, it could conceivably take a while, even a year or two, to start dropping. Bull markets can go on for years.

Time is money as they say, and if you are paying interest on a margin loan to borrow the stock in the first place, having to wait for a year or two for a potential profit is not a good idea.

Shorting by Company Directors

A more recent phenomenon relating to selling stock short has involved company directors taking out large margin loans to buy (long) more of their own company's stock.

In a market downturn with prices falling, aggressive shorting of stock can drive the price of the company's stock further down.

This can, and has, forced some directors who are in vulnerable positions to become exposed to margin calls that force them to sell their company stock at depressed prices to cover their positions.

This causes the stock price to fall further ... and a downward spiral ensures that reaps profits for the short sellers, and has brought some companies to their knees, together with some of their stockholders.

It is becoming obvious that stock market regulators need to tighten the rules for short selling before stock markets start to appear more like gambling casinos.

Value investors need to be made aware of the margin loans of company directors in order to adequately assess the risk of owning the company's stock ... and also to adequately protect them from the predatory behavior of short sellers.

To Conclude

Shorting stocks may be appropriate for absolute return fund managers and hedge fund managers who are dealing with large holdings and use stock shorting as a hedging strategy to protect against downturns.

Individual value investors may be in a better position than most to determine whether a particular company is seriously overvalued, they have an alternative strategy available.

And that is to commence staggered selling of their stock to reduce their exposure to a potential downturn.

The unique risks of selling stocks short makes shorting a stock a speculative strategy - and one I don't engage in.

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