Guide to Short Selling

Have you ever had a strong conviction that a stock was headed for a substantial drop, and wished to profit from its decline? What if a massive run-up in a specific sector (like technology in the late 1990s or commodities from 2003 to 2007) leads you to believe that a significant correction is possible and you would like to make money from this view& Or say you wanted to hedge the inevitable decline in your portfolio during a severe bear market. Short selling enables you to potentially benefit from each of these scenarios.

Short selling makes it possible to sell what one does not own. This is a key concept, but how, you might ask, is this possible? In simple terms, you execute a short sale by borrowing the asset or instrument that you wish to short sell, and selling it at the current market price. If and when the price of the asset declines, you buy it back and return it to the lender to “cover” your short sale. The difference between the price at which you sold the asset and the price at which you bought it back represents your gross profit or loss.

As you can see, short selling follows the conventional investing principle of “buying low” and “selling high” but with one critical difference – the sequence of the buy and sell transactions. While the buy transaction precedes the sell transaction in conventional “long only” investing, in short selling, the sell transaction precedes the buy transaction.

When you short sell, you create a short position or a shortfall. A short position represents a binding obligation that must be closed or covered at some point. This “short covering” obligation gives rise to one of the biggest risks of short selling, as discussed later in this tutorial. 

Short selling is also known as "shorting," "selling short" or "going short." To be short a security or asset implies that one is bearish on it and expects the price to decline. Short selling has also spawned some of the most colorful terms in the investment lexicon, as discussed in a later section (Ethics And the Role Of Short Selling).

Short selling can be used for speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or the broad market. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio. Note that institutional investors and savvy individuals frequently engage in short selling strategies simultaneously for both speculation and hedging. Hedge funds are among the most active short sellers, and often use short positions in select stocks or sectors to hedge their long positions in other stocks.

Short sellers are often portrayed as cynical, hardened individuals who are bent on making profits by driving the companies that are their “short” targets to failure and bankruptcy. The reality, however, is that short sellers facilitate smooth functioning of the markets by providing liquidity, and also act as a restraining influence on investors who may be prone to chase overhyped stocks, especially during periods of irrational exuberance. In the absence of the reality check provided by short sellers, stocks may trade at stratospheric levels and ridiculous valuations; investors who buy such stocks at these inflated levels could face steep losses in the correction that follows, as boom turns to bust. 

A handful of short trades succeeded so spectacularly that they have become the stuff of legend. One of the best known short trades is George Soros’ short selling of the British pound in September 1992, which forced the currency out of the European Exchange Rate Mechanism and netted Soros $1 billion in the bargain (see  How did George Soros “break the Bank of England?”). Another spectacular short trade was hedge fund manager John Paulson’s bet against U.S. subprime mortgage securities that made his firm $15 billion in 2007.

More recently, hedge fund manager Bill Ackman’s massive short on nutritional supplements company Herbalife has attracted plenty of headlines and earned Ackman the ire of another hedge fund giant, Carl Icahn. The tussle between Ackman and Icahn – who owned 22.9 million shares or 24.6% of Herbalife as of March 2017 – has become a classic battle between the “shorts” and the “longs”, and may take years to be decided in the marketplace.

Short selling is viewed by many investors as an inordinately dangerous strategy, since the long-term trend of the equity market is generally upward and there is theoretically no upper limit to how high a stock can rise. But under the right circumstances, short selling can be a viable and profitable investment strategy for experienced traders and investors who have an adequate degree of risk tolerance and are familiar with the risks involved in shorting. Relatively inexperienced investors would also do well to learn about the basic aspects of short selling through learning tools like this Tutorial, in order to expand their investing toolkit.  

 

This commentary was prepared by Elvis Picardo, who is a Portfolio Manager with HollisWealth® (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). This is not an official presentation of HollisWealth. The views, including any recommendations, expressed in this presentation are those of the presenter and are not necessarily those of the dealer. All investments involve risk and prior to investing, the specific risks should be discussed with an investment professional. ® Registered trademark of The Bank of Nova Scotia, used under licence.

This commentary may contain forward-looking statements based on current expectations and projections about future general economic factors. Forward-looking statements are subject to inherent risks and uncertainties which may be unforeseeable, and such expectations and projections may be incorrect in the future. Forward-looking statements are not guarantees of future performance and you should avoid placing undue reliance upon them.