What is a Short Sale in Finance?

Fundamentals ·

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What is a successful trade? Well, we may say that any trade that generates profit might be considered well executed and it's usually done by buying some asset, waiting for its value to appreciate and then by selling it for a higher price. You buy low and your sell high, that's how most investors make money.

However, there is an alternative way to make a profit: you can borrow a particular asset and sell it for cash with the intent to buy it back later when you decide to return your loan. The key is that any depreciation in the value of that asset would mean that you have to pay back less money than you initially took, allowing you to profit from the price difference. This counterintuitive deal is called a “short sale” (short, shorting and going short).

Illustration

Illustration by Eugene A

In this article, we'll explain the concept of shorting and we'll also show you some real-life examples of short trades.

History

The practice of shorting isn't new: it dates back to 1609 when it's was used by a Dutch businessman Isaac Le Maire.

Short selling is a controversial activity and many governments imposed severe restrictions on short trades troughout the history of stock market. There is an eternal conflict between people who are long on particular assets and the people who are short on them. Making money on short trades is often viewed as preying on the suffering of other people.

Definition

When you first time hear “going short” or “open a short position” you might assume that it means that you won't hold this position for a long time, and a long trade means the opposite - to hold the deal for a month, a year or longer.

The truth is that shorting has nothing to do with time frame or time horizon, it's about a specific kind of market operation. In trading, “short” means to sell, and “long” is understood as to buy.

“To short” a security or an asset means to sell it first, and then to buy it back later when its price goes down. This deal can be called counterintuitive because the classic market thinking is the opposite: you buy an asset at a cheap price, and then you sell it when the price is up.

Note that there is also the “Short Sale” term in real estate business with a different meaning.

Naked and Covered Short Positions

There are two main kinds of short selling:

  • Naked
  • Covered

Naked short selling is when one sells an asset without first borrowing it (without a cover).

If the short seller of a stock doesn't acquire it before the required delivery period, the result is known as a failure to deliver.

This is problematic because by opening a large number of naked short position market participants have the power to push the price down, yet they aren't obligated to close their positions or to cover them.

In 2008 SEC banned naked short selling in the US.

Some regulations regarding this type of short selling also exist in Australia, India, Netherlands, Japan, Switzerland, and Spain.

Covered Short selling is the standard process of short sell in which they can borrow funds using collateral, sell it and then repurchase it. In this case, an investor is required to use a cover and to borrow the asset first. To execute this deal an investor must have a margin account.

Margin Requirements

Covered short sell trades are placed on margin which means that there are the capital requirements for such kind of the deal.

Federal Reserve Board in the US requires to have 150% of the amount of the short sale on your account to cover the deal (source), so if your short trade is for $10,000, you must have at least $15,000 on your account in total. In this case, as the value of the shorted assets is equal to $10k, you'll be required to have an additional $5,000 to execute the trade.

Margin requirements imply that there is always a risk of the margin call if the required amount of funds isn't present.

The logic behind these requirements and regulations is quite simple.

The standard type of the market operation, when you buy and then sell an asset, can be done with a leverage (on margin) if the trader prefers to do so, however, it's not obligatory because the trader has to buy an asset first with his own money to sell it later.

With a covered short sell, the leverage is required because one doesn't own the asset prior to the sale.

How Does Shorting Technically Work? Examples

Here are two simple examples of the covered short sell deals:

Example 1

A hypothetical investor owns 1000 shares of company X, the current price of which is $5 per share ($5000 value). He short sells those shares right now, which might be a bit confusing because one would assume that he'd just get 1000$5 revenue immediately and the story ends. However, because it's not just a sell, but a short sell, he has an obligation to buy his shares back later. Technically, he'd get 1000$5 revenue (+$5,000) after the sale, but the deal isn't over yet. When the price of the shares drops down to $4, he then buys his shares for 1000*$4 (-$4,000) and the total profit he gets is $1000. Basically, this was the same deal as any other “normal” trade transaction, but it happened in reverse.

At the end of the day, this trader would have his initial 1000 shares valued at $4000, but in addition to that, he made a profit of $1000 on the short sale already, thus his total capital equals to $5000. It may seem to be the same position as he was in the first place because the total value is the same, however, without such short trade this trader would have his portfolio valued as $4000 if the current price of his shares dropped to $4.

If this trader felt like the price going to go down he could just sell (just sell, not short sell) his 1000 shares at $5 each and keep $5000 of cash, but the short sale he executed in our example left him with the same total capital and with the shares as well, which he can sell later if the market turn back and the bull trend returns. In this case, the short sale gave the trader a bit fore flexibility.

Example 2

A hypothetical investor holds no shares at the moment but he wants to short sell some shares of company X. Those shares are currently priced at $5 per share, the same as in the 1st example. To short sell those shares he has to borrow them first from a third party (a lender). He borrows 1000 shares and then short sell them right after that at $5 each. After a while, luckily, the price does down to $4 and he buys those shares back with his real money (-$4,000). Now that he has the shares he gives them back to a lender at the price there were initially purchased (+$5,000).

What'd a naked type of short sell trade look like? It'd be the same as the 2nd example but without the borrowing part. An investor would just short sell the shares that he doesn't have at all. You may see why this practice can be seen as dangerous. When the shares are borrowed before the short sell, which may seem like an unnecessary technical procedure, at least the lender will be interested to get his shares back sometime in the future, which makes the trade more secure and forces the investor to close the deal at some point to give back the shares that he borrowed.

What Happens if the Market Goes Up?

Short selling allows one to make money during a downwards price trend, but what happens if an investor opened a short position and the market went up? In this case, this investor will lose money as he made the wrong bet and when the value of his positions falls down (as the price rises) he might experience a margin call that will close all his positions automatically.

The most famous real-life case when something like that happened was in 1901 when the shares of the Northern Pacific Corner railroad went up from $170 to $1,000 in a single day, many traders held a lot of short positions and that lead to a catastrophe.

You can read the full story on americanheritage.com.

Understanding Short Selling

This concept of short selling can be quite confusing to people as they might not understand how can you sell something that you didn't buy before.

How is it possible to sell an asset that you don't own?

It might even sound like some kind of a scam, like the story of Victor Lustig, who sold the Eiffel Tower twice, which he obviously didn't possess.

However, covered short sell deals are 100% legal and the creation of this instrument was a logical evolutionarily step in the market's development. If there is a way to make money during a bull trend, when the prices go up, there has to be a way to make money during a downfall of the market. Short sale deals served exactly this purpose - to allow market participants to make such a bet on a “negative” turn of events. This tool changed the whole understanding of the market as it became possible to make money on price movements in any direction.

Short Selling as Hedging

Short selling is sometimes used as hedging to protect an investor from unexpected loses.

Imagine that you are a long-term conservative investor who bought 5000 shares of a company at $10 per share. These shares are expected to be not volatile, so it's a safe long-term bet with a low expected return. Let's say that you had this position for 5 years and it performs as well as expected. Sadly, some bad news just came out that this company's shares may experience a brief downfall in its price soon, what can you do in this scenario? Let's also assume that this company is paying nice dividends so you don't want to close your long positions right now.

In this case, you could open a short sale position to benefit from the expected downfall of the price.

With this short position, you'll still be holding all your shares when you open your short positions, so if this is just a temporary price dive you'll make some money off it and keep all your shares. If this is something bigger than that, maybe a fundamental collapse, your short positions will help you to reduce your total losses as you opened positions in both directions simultaneously.

This is just one example of hedging that provides flexibility, there are many different models and some of them can be quite complicated.

Criticism and Historical Examples

Short selling attracts a lot of criticism because many people believe that those “bears” (traders and investors who are betting on the crisis, downfall and a recession) are making a bad situation even worse by pushing the market further down.

A famous example here would be to recall the story of how George Soros made a portion of his fortune.

During the 1992 Black Wednesday UK currency crisis, he made a profit of $1 billion from a short sale. Although everything he did was perfectly legal and he wasn't the only person who made money on this crisis, he is often blamed for it, as well as for some other things.

People tent not only criticize those who play against the growing market, they even blame them when the market trend turns around. It's obvious that any market can't have a constant and infinite growth, there'll be a crash eventually, yet many people refuse to be prepared for such a turn of events.

It's true that traders can push the price down and speed up this process, but often the turn-around happens because of the inflated and overpriced market expectations of the majority rather than because of a small group of people who allegedly crushed the market by their actions.

Another colorful example of a trader who loved to short sell is Jesse Livermore, who we already mentioned in the article about the differences in investing and trading. During the market crash of 1929, he made approximately $100 million and got a nickname of the Great Bear of Wall Street. He was often blamed for the downfall, yet the core of his philosophy was that you can't play with the market and you can't control it. He believed that you can't change the trend with your actions even if you have a lot of financial recourses and act as a group because the market lives its own unpredictable life and it's close to impossible to influence price movements in the long-run.

Current Use

Today shorting is wildly used in trading liquid public securities, futures or currency markets. Almost any modern trading platform allows a portfolio manager to short sell any asset as simple as to execute a “normal” kind of “buy low, sell high” deal.

Cultural References: The Big Short Movie

In 2015 a film about the financial crisis of 2007–2008 called “The Big Short” was released.

This is a great movie featuring Christian Bale, Ryan Gosling and Brad Pitt where authors concentrated precisely on the short sale.

When the housing market was hot and no one saw the bubble, a few weirdos felt that something is wrong at an early stage of the crisis. This movie tells the story of 3 groups of people who were able to predict the major collapse and to make money off it by short selling.

If you don't quite understand what a short sale is and you don't want to read books or articles about it, you can just watch this movie and this would give you a good basic understanding of this concept.

Young investors Charlie Geller and Jamie Shipley in Brownfield Capital figured out to short high-rated AA mortgage securities that nobody expected to be failing, other “heroes” (Michael Burry, Jared Vennett, etc.) in the movie also made a lot of money by boldly betting against the market.

This movie is interesting because it doesn't show those “bears” as the bad guys, it presents them as geniuses with a strong will, who were willing to risk a lot, do deep and independent research and survive the pressure.

Should I Practice and Use Short Selling?

Short sell deals are definitely a bit more complicated than the classic type of the deal, thus it shouldn't be practiced by beginners and immature traders. Short sell is confusing at first, it's somewhat illogical and irrational too because people tend to expect that the price will go up and that a bull trend is always a good thing for everybody.

Another problem with short selling is that it's often done with margin, which makes those deals far more risky as your potential losses are unlimited. Several sources are warning traders to avoid short selling due to their in-built risks.

That being said, short sell in today's world is the crucial and necessary instrument used by all major investors and traders, therefore at some point, you should start learning it and practice to predict not only a bull trend but a bear trend as well so you can always make money.

finance  ·  investing  ·  market  ·  strategy  ·  technical analysis  ·  trading  ·  trends

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