Short selling (often called “shorting”) is an integral part of becoming a rounded trader. Markets go both directions. Being willing to short sell is a key element in some plans, such as spread trades.

Due to regulatory mandates, certain investment managers, such as those running mutual funds, are not permitted to sell short. You are also not permitted to short sell on numerous apps, like Robinhood, outside of buying items like inverse ETFs. (Inverse ETFs go up in price when the underlying market goes down.)

Most traders don’t want to sell short at all even though they can. It’s generally due to worries about the danger involved or that it doesn’t make any sense in relation to their company. For example, Warren Buffett isn’t a short seller.

Others don’t want to sell short due to their thinking that it’s hard to make money being short hazard premia. In other words, people buy financial assets, including equities and credit, because it’s widely known that they can outperform cash returns in the long run. This is called a premium, typically expressed as an extra annual return rate. Traders and investors anticipate risk-taking rewards.

Therefore, if you’re short-risk incentives, it can be hard to make money as the long-run financial asset markets continue to grow. Too many prefer to go with the flow and just buy (i.e., be long) financial assets because they expect to make money that way, particularly by long-term holding.

For example:

Where in 10 years’ time will Apple stock be? Likely higher.

Where is Google stock from now on going to be 10 years? Likely higher.

If you invest in 10-year US Treasuries, you are very likely to have made money 10 years from now by simply keeping them all the while.

Short selling is much more of a form of trade than of investment. Through the years, it is normal for people to “buy and hold” properties, but far less normal to keep shorts for long periods of time. For equity markets, down movements and sell-offs appear to be faster than up movements (“escalator ride up, elevator ride down”) making short selling more of a pure trading term.

The Mechanics of Short Selling

Short selling means borrowing an asset which is not owned by the seller. The short seller borrows and sells the asset from a lender (i.e., a bank, private investor, market-building institution or whoever may own it). The seller repurchases the asset on the market when a short position is closed, or “covered,” and returns it to the lender to meet the initial sum borrowed.

By this method, if the price falls, the short seller makes a profit. That is because the selling price was smaller than original sale proceeds. If the price goes up, this method would result in a loss for the short seller because the original proceeds of the sale are less than the amount of the repurchase.

Naturally, the target of short selling is to “sell big, buy low” instead of “buy high, sell low.”

Since borrowing involves short selling, this also includes a fee, similar to a loan. For example, if certain stocks have high floats (i.e., a large number of outstanding shares) and enough equity owners are willing to lend out shares for cash, it would be possible to sell short.

The fee is mostly 1 percent-2 percent interest per year for “quick to borrow” shares. The price may be exorbitant to the point that it makes short-selling completely off-limits for “hard to borrow” shares.

For example, when Tilray stock (NASDAQ: TLRY) reached new all-time highs at breakneck pace in September 2018, the borrowing costs associated with stock shortening were around 1,000 percent. It has to do with strong demand to shorten it (the stock was in a trading frenzy) combined with a weak float due to its post-IPO lock-up (the support to make sure the IPO succeeds in minimizing the availability of circulating shares).

Occasionally, traders who earn interest on the currency balances may also carry on their shorts with positive outcomes. When the base currency of a trader provides interest rates above the cost of shorting overnight, it will deliver positive carry.

What Markets Short Selling is Most Common

Short selling on stock, currency and futures markets is the most common. This also happens in the public credit markets (i.e., shorting bonds), but is less common given that bond markets are typically less liquid, and shorting costs are higher.

Short selling in currency and futures markets is prevalent. Such markets are not directionally selective, are always liquid, and prices are known in real-time. Currency shortening also varies significantly from short selling stocks. Currencies are phrased in pairs.

For example, if you’re low on the EUR / USD, that means you borrow euros to buy US dollars. You buy back the euros and sell the dollars when you close the spot, or “cover” it as it is widely referred to. If the euro is down in value compared to the US dollar, this trade would yield a net profit. When the euro increases in value against the US dollar, the trade would result in a net loss.

Short selling on the stock market is relatively less usual despite the favorable risk premia associated with holding equities and the expense of shorting.

Traders would also look at the “short interest ratio” to gauge the short interest in a specific stock. This takes the number of short shares, and divides by the total number of shares. This figure is below 10 per cent for most stocks. The number would continue to be higher for stocks which are experiencing financial and operational problems.

The Short Selling Risks

If you purchase an asset, the risk is limited to losing everything (the asset goes to zero). However, technically, when you shorten an asset the chance of failure is infinite. If you sell short, in turn, you can lose more than anything. That’s because if you’re short and the asset price more than doubles, you’re going to be out more than 100 per cent and owe your broker money.

Brokers are helping shield themselves from this danger by allowing traders to post margin on their shorts.

The Ethics of Short Selling

Stock Markets

Nevertheless, short selling is a controversial subject, particularly as it relates to short equity. A stock interest reflects a stake in a company’s holding. If the stock goes up, this means the company’s market value rises. This is generally good news for its creditors, its workers, its vendors, other stakeholders and the wider economy.

Short sellers are often criticized for hoping companies will fail so they can benefit from a decline in their price. This can cause politicians and other segments of society to engage in conflict and retaliation. Business management is not entirely prone to strike, accuse of malfeasance, and/or bring lawsuits against short sellers in a business. We saw this partially with Enron (although eventually short sellers were right). Today we see Elon Musk targeting short-sellers of Tesla shares among the high-profile names.

Regulators can opt to thwart short selling under volatile financial conditions, assuming it will help calm the dynamics of the market. This happened in 2008 as traders piled into short positions against Lehman Brothers and Bear Stearns.

Yet short selling is an necessary element for capital markets to work effectively. The ability to shorten will help to curb speculative bubbles (e.g., late-2017 bitcoin) and ensure a healthy price discovery.

In fact, short sellers may also point out potential company-related issues or malfeasance. Often it’s short sellers – rather than regulators – who discover questionable, immoral, or dishonest undertakings when they’re in businesses with regard to accounting or other behaviour.

It is also not established that banning short selling, or at least strongly restricting, makes for calmer market behavior.

Currency Markets

Also, seeing short selling shunned in currency markets is not atypical, but not to the same degree as in stock markets. For example, not shortening the domestic currency is considered a source of national pride in banks in some countries.

George Soros’s 1992 British pound short, also known as the exchange that “broke the Bank of England,” received public backlash. Traders working for Soros, however, had determined that the Bank of England did not have the funds necessary to hold the pound within the European Exchange Mechanism (ERM), a European Monetary Union integration predecessor, at a rate of 2.7 German marks per pound.

The additional pressure from the short selling had forced the hand of the bank. In fact, keeping the pound within the ERM was unsustainable given the high inflation rate of Great Britain, which was officially above 8%.

Short Selling

In the end, pushing Great Britain out of the ERM was advantageous as it permitted natural market forces to control the exchange rate. Inflation washed out of the British economy and inflation has largely not been an problem in the UK ever since.

Shorting is not illegal in any case. When short sellers are correct they actually expose market price inefficiencies.

Alternative Forms of Short Selling

Not all short selling takes place through the securities lending process. Broadly speaking, shorting will include any instrument a trader may use to benefit from a decline in the price of an asset.

Shorting can be done through futures contracts, options (e.g., buying puts), or swaps. While these instruments may be used for short selling, when the trade is made, there is no immediate delivery of the underlying asset.

Overview of Short Selling Strategies

Outright Short (Unhedged)

Short selling can be seen as an outright bet on a particular asset or security falling down. Some traders can unfavorably view the fundamentals of a given market and decide to shorten it accordingly.

Example

U.S. Treasury Bonds are a heavily shorted market as of November 2018.

Short Selling

The research on this idea derives from a number of angles.

First, the US Federal Reserve is raising interest rates and expects them to climb further than investors would expect based on the forward rate curve. All rates for financial assets are assessed partly on the basis of interest rate expectations. Investors believe this would place undue upward pressure on bond returns.

In addition, the Fed is tapering its balance sheet of assets accumulated in the wake of the financial crisis of 2007-09 to further support lower yields along the curve. That includes a monthly $30 billion in Treasuries and a monthly $20 billion in agency debt coming into the market.

Besides that, the US is running a rising fiscal deficit. This requires the issuing of new Treasury bonds to fill the funding gap. That is more than $100bn a month.

In terms of basic economics, prices will collapse if supply exceeds demand.

Many of the Treasuries margin buyers are international central banks. Global reserve growth is about flat, and international central banks are approximately maxed out in terms of how much Treasuries they are able to purchase on the basis of conventional allocations. Which means the US would have trouble finding enough customers for them.

Traders look at this and see Treasuries as an opportunity to cut short. This implies that they expect prices to fall and the yields to rise. (Price and yield have an inverse relationship.)

The negative carry risks to the risks to the thesis. If you’re shortening something by dividend or coupon, you’re paying that. As far as price dynamics are concerned, there is always the possibility that private investors will pick up the slack in the market if Treasuries look increasingly attractive compared to other asset classes, particularly stocks and commodities.

More technically-focused traders would see things like momentum, overbought/oversold indicators, levels of support and resistance, moving averages, and other such things as validating a short concept.

A technical analyst might point out the level of resistance in the chart below and watch it as a potential field to be shortened.

Short Selling

Hedged Short

Some traders go short of other securities to reduce their market exposure. For example, for a trader who expects ExxonMobil stock (XOM) to outperform the oil and gas market, may go long XOM but short a basket of other oil and gas stocks, such as an exchanged traded fund (ETF) like XLE.

Most equity hedge funds are long and short, and usually a combination of 150% long and 85% short.

Many traders do shorts of relative value, where one asset goes long and a similar one is short. They benefit if the price rises spread.

Traders may also be short to mitigate risk from a particular market factor to which they do not wish to be exposed.

Example #1

For instance, a trader does not want “momentum” exposure (a kind of factor investment exposure) and hedge any net momentum-related risk by shortening a portfolio of assets that reflect it.

Example #2

A trader may not want net exposure to the U.S. dollar, as he will get by being short stocks of gold, oil, euro, and the U.S., and want to hedge it out. That could be achieved by going on long futures for the US dollar and calculating precisely how the exchange of currency needs to be effectively hedged.

Example #3

Market makers may build very skewed portfolios to be long or short whatever assets they trade with. If a market maker formed a long book of equities, he would be inclined to sell short futures for the risk to be mitigated. Many other asset groups will do this. For a fixed-income market maker, he can also choose to offset his book’s interest rate risk and credit risk profiles via futures contracts.

Example #4

Farmers, oil company executives, metals and mining executives, and other individuals in highly unpredictable commodity prices-linked businesses will also try to hedge their exposure to the inputs most closely tied to their business performance, which will help smooth the company’s earnings expectations.

Example #5

Traders with options also wish to be delta-neutral. For example, if a trader is a long call option and the underlying option delta is 0.5 (i.e., the option value shifts by + /- 0.5 percent with each + /- 1.0 percent shift in the underlying), he would shorten twice the shares contained in the call options. That will hedge the trade from underlying movements.

If the trader has bought 100 contracts for the call option, that means that 10,000 shares of that particular stock are in fact long. (There are 100 shares per contract.) When the option delta is 0.5, it will sell 20,000 shares short to fully hedge against the underlying price fluctuations affecting the benefit and loss of the deal.

Example #6

Some proprietary trading shops can make the market more competitive by using arbitrage strategies. You may opt to do so, for instance, through ETFs, which are equity instruments that follow a specific asset basket.

The ETF’s net asset value (NAV) would often be out of line compared to the market value of the assets found therein. That provides an incentive for arbitrageurs to trade. If the NAV of the ETF is priced at a premium, traders that look to shorten the ETF and go the portfolio of assets it contains for a long time, hoping that the two would eventually have to fall back into balance. If this happens they’ll benefit from the rebalancing. Likewise, if the NAV trades at a loss, traders would look for the ETF to go long and the asset basket to short sell.

Protecting Against The Risks of Short Selling

A lot of traders use a stop-loss when selling short. This will work to protect or to buy back the position if the asset price increases to a specific amount. This helps to prevent the problem of not only a significant loss but also the possible infinite loss.

Traders do need to consider the potential for “short squeeze”. Traders are prone to the need to cover in order to reduce their losses when they have a relatively large position size. This also happens by using stop-losses or margin-calls. If the group that had borrowed the stock decides to sell its shares, others might be compelled to cover.

A short squeeze includes the purchasing of shares, which sometimes induces a rise in the price of an asset. In a self-reinforcing way this may trigger additional covering. Short squeezes can also be triggered by investors or companies actively wanting to to get short sellers from their positions. This is achieved by buying a fairly large quantity of shares, which allows stop-losses and margin calls to occur.

The trick to avoid a squeeze is to watch the size of your position. If you are apprehensive about the possibility of a role shifting against you 20 percent-30 percent, then you are too big. The goal for institutional investors is never to become too large a part of the market.

Conclusion

Short selling is an important part of free market trading. Markets move in all directions and restricting yourself to being just long on the market can be overly restrictive. You should plan to be short on the currency markets just as much as your long given currencies are expressed by pairs.

Despite ethical concerns and even legal challenges, there is little evidence that bordering the practice makes financial markets more effective over the years and across various jurisdictions globally. Short-sellers powered by research also work to help ferret out fraudulent conduct within a business.

Strategically, traders may either shorten outright, or as part of a policy of arbitration or hedging.

Managing the potentially infinite risk inherent in short selling can be achieved by a few key ways: (1) using a stop-loss, (2) never betting too much, so that an adverse price change does not “squeeze” you out of trade, (3) avoiding markets that aren’t liquid, and (4) not shortening assets that are already heavily shortened, creating a higher probability of a short squeeze.