Profiting from a decline: how short selling works

Profiting from a decline how short selling works
Photo: Yastremska, BS

Making a profit of the economy revolves around one core subject, you buy low and then you sell high. The retail business is built upon this core principle. The concept of flipping, purchasing an asset only to sell them for a higher price in a relatively short amount of time works the same way. There are numerous reality TV shows designed around people purchasing run-down properties and then renovating and flipping them for profit.

If you’ve ever been to a concert or a sports match, you are no doubt familiar with scalpers, selling inflated ticket prices to prey on late attendees. Trading in the financial market too mostly follows the same concept but as any trading courses would tell you, there is a segment of traders who work on the opposite direction, making a profit from declining asset prices in the market. These traders are what the industry refers to as short sellers.

The basics of short selling

The Big Short, the 2015 Oscar-nominated film featuring the likes of Christian Bale, Steve Carell and Brad Pitt, helped popularize the concept of short selling. The film, which was based on real events surrounding the 2008 global financial crisis, depicts a group of traders who saw the coming crash of the real estate market and essentially made a bet against the large US banks at the time. They eventually won and one of the characters is depicted as ending up with a profit of US$2.69 billion.

In this way, the practice of short selling is similar to the concept of contrarian investing. Both involve investors and/or traders going against the flow of the market by taking an unpopular position, essentially going against the market, but that’s where the similarities end. Contrarian investing still follows the same principle, you buy shares from a company, usually one that’s overlooked by the market, in the hopes that that company will grow or bounce back in the near future.

Short sellers on the other hand work by anticipating a correction or a crash and try to make a profit from the declining prices. It doesn’t make much sense trying to make money when prices go down but short sellers are able to do this by using borrowed assets. To better illustrate this point, let me give you a rough example.

Trader A analyzes that at this moment, company B is vastly overvalued at a price of $150 per share. Trader A borrows 100 shares of company B and immediately sells them for $15,000. Right now, Trader A has $15,000 sitting in his account and just as he predicted, shares for company B underwent a correction and is now sitting at $100 per share. Capitalizing on the moment, Trader A bought back 100 shares for $10,000 and returned those shares but with a profit of $5,000 now sitting in his account.

Why short selling can be risky

Touching stock market graph on a touch screen device.
Photo: Bloomicon, BS

At this point, it might not seem that short selling is inherently no more risky than the typical trading methods but a deeper look would reveal that that’s simply not the case. Assume for example you’d like to buy shares of a company at $10 per share. It is impossible for those prices to go lower than $0 because money does not work that way so at most, you’re looking at a loss of $10 per share if you do decide to open a position in that company.

In short selling however, there’s no limit on the money you could potentially be losing. Prices will rise as long as there’s demand from the market, which means that for short sellers the potential loss is theoretically limitless while the potential for profit is capped at 100%. One other thing worth mentioning is that it is possible for the lender to recall the shares you’ve borrowed without prior notice, automatically closing your position, no matter how will this impact you.

Is short selling legal?

In most markets it is, but short selling is usually more regulated than conventional trading. The Australian Stock Exchange for example only allows short selling on certain stocks. This is partly due to the relatively negative stigma related to the practice of short selling itself. The problem with short selling is that you are essentially profiting out of someone else’s misery. One other issue is the prevalence of ‘short and distort’, in which short sellers spread dubious rumors in order to push prices down.

Trading is indeed a zero-sum game in that for there to be winners, there has to be losers but short selling takes that idea to the extreme. In the example from The Big Short film, those traders made billions while a lot of the average Americans at the time lost their houses and their jobs. Betting that the market will go down at some point and trying to somehow make money out of that reeks of cynicism at best and ethically compromised at worst.

Closing thoughts

That being said, short selling isn’t necessarily all bad. Short sellers, like all short-term trading courses provide the marker with liquidity. Still, because of the associated short risks, brokers usually attach higher fees for traders to open a sell position. In lieu with this knowledge, only experienced traders should engage in the practice of short selling.

 

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The views expressed on this page by the author it’s their own, not those of Best in Australia, and it shouldn’t be considered as advice.