For most people, investing means buying stocks or bonds with the expectation that their price will rise over time or to earn income. They earn money when the price goes up and lose money when it goes down.
However, some savvy professional investors seek to profit when prices fall through something called short selling. This is a common strategy used by hedge funds and other institutional investors like pensions and insurance companies who buy securities in bulk.
While being able to profit from the ups and downs of the market may sound appealing, it is a high risk strategy and most investors should stay away. Short positions have potentially unlimited losses and require precise timing. High trading fees often make profits even more difficult to achieve.
How the short circuit works
Investors who wish to take a short position will borrow stocks from a broker or other large investor and sell them in the market at the current price. If the stock goes down as they predicted, they can buy back the stock at a lower price and return the stock to the broker.
Take the example below:
Past performance is no guarantee for the future. Source: Refinitiv, as of 03/25/2021.
Imagine you had to borrow this stock to sell it in the market when it hit £ 4.00 per share. Two months later you could buy it back for £ 1.30, return it to the broker and pocket the difference of £ 2.70, excluding trading fees.
Looking back, this looks like an attractive strategy. After all, a long position is unlikely to provide that kind of return in such a short time. But what makes short selling problematic is that the losses are potentially limitless unlike traditional investing where you can’t lose more than what you invest.
In reality, if you invest in the stock market, what you get will depend on the underlying investments and their performance. You could lose what you invest and any potential income, so you could still suffer a loss.
Here is another example:
Past performance is no guarantee for the future. Source: Refinitiv, as of 08/08/2019.
This is the share price of an oil company that was struggling to manage its cash flow as oil prices fell. Suppose you borrowed stocks and sold them in the market for $ 45 in April, expecting more lows to come. A few days later, the group becomes an acquisition target and a bidding war between two large companies breaks out. The stock jumped to over $ 70 per share, leaving you with $ 25 in losses on each share in a matter of weeks.
Even a stock that looks destined to fall can rise if the conditions are right – this is what makes short selling so dangerous. Everything from an acquisition to a Reddit-inspired frenzy can make a short position go bad quickly.
Short sellers don’t have diamond hands
Some short sellers will resist when a stock rises in the hope that it will come back down and make their trade profitable – or at least less profitable. But to do this, they must prove that they have the financial resources to reimburse their broker if their prediction turns out to be wrong.
Brokers generally require short sellers to maintain a minimum cash balance equal to the amount owed to them. As a short stock increases, the broker will increase the minimum balance. If the investor cannot deposit the required amount, the borrowed shares are recalled, forcing the investor to buy the shares at the current market price. Institutional investors set similar limits to cap the losses they are willing to accept.
These minimum balances can trigger what is called a “short squeeze”. When many investors have taken a short position in a particular stock and the stock starts to rise, some will try to buy stocks to avoid further losses. This can push stocks up and cause a chain reaction as brokers force more short sellers to close their positions. Thus creating a tailwind for an otherwise struggling stock, driving up the price.
One of the most notable examples of a short crunch dates back to 2008, when, for one day, German automaker Volkswagen became the world’s most valuable company. A few days earlier, Porsche had announced that it had taken a 74% stake in VW’s voting shares, which sparked acquisition rumors. The rise in the share price caused a cascade of buying, with short sellers being forced to close their positions, pushing the shares above 300%.
Past performance is no guarantee for the future. Source: Refinitiv, as of 12/31/2008.
Why Institutional Investors Use Short Selling
Institutional investors have often resorted to short selling to hedge their portfolios and reduce risk. Along with long positions, fund managers sometimes also take short positions.
Short positions can be a prediction of what could be the next step for the company or industry, as explained above. But more often they are used to cushion the blow of an unexpected decline. This way, short positions can reduce some of the profits from a long position, but they also prevent the fund from hemorrhaging cash in a downturn.
This strategy became evident during the stock market crash in March when some fund managers were accused of taking advantage of the market’s desperation.
Bill Ackman was cited as an example after bringing in $ 2.6 billion from a short position. Ackman was notoriously bearish in emotional talks in March, which led to questions about his motives. While no one can say for sure whether Ackman was genuine in his interview, the short position that grossed $ 2.6 billion in March was most likely a cover. He lost a similar amount in long positions, which means that the hedge has done its job of protecting against some downside risks.
Selling short as part of a calculated strategy to minimize risk makes sense for some institutional investors. But as an opportunity to profit from a downturn in the stock markets, it fails.
We believe that the risks of short selling are ultimately not worth the potential gains for retail investors, especially when you factor in the costs of trading. No one should invest more than they want and cannot lose. Selling short can cause you to suffer much larger losses than you expected and even more than what you initially invested.
This article is not personal advice. Investments can go up as well as down in value, so you might get back less than what you invested. If you are not sure which investment is right for you, please seek advice.
Explore our Investment Times Spring 2021 edition for more articles like this.
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