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What is Short Selling?

“Short selling” is a controversial subject amongst investors because it involves taking a negative view on a company and seeking to profit from a fall in the company’s share price. Naturally, this can be upsetting for those who have the opposite view and have invested in the company. In this article I set out:

What is meant by selling short and how it is done
When there are problems with short selling
Risks involved in short selling
Why it can be worth paying attention to those who are short

Readers who are full members of ShareSoc may also find it useful to watch one of our Full Member Exclusive Masterclass Videos from November 2020, where experts discuss short selling strategies.

Selling Short

“Selling short” means selling shares you don’t own, in the expectation that you will be able to buy them back later at a lower price. For example, if you sell a stock at 100p and then “cover your short position” by buying it back at 50p at later date, you make a 50p profit on each share you sell. It’s exactly the same as buying a share at 50p and then selling later at 100p – except that the two trades are conducted in the opposite order! At first, this might sound like an oxymoron: how can you legitimately sell something you don’t own?

Stock Lending

There are two ways that a stock can be legitimately “shorted”. The first, used principally by institutional short sellers (eg hedge funds), is to borrow stock from another institutional holder (eg a fund) and then sell it. To do that, you have to enter into an agreement with the stock lender that you will return the stock to them at a later date. Why would an institutional holder lend stock? The answer is that the lender can charge fees to the borrower, so this is a way that the lender can earn money on their holding even without the share price moving or receiving dividend income from the stock.

Speaking of dividends, the stock-lending agreement will also stipulate that any dividends that accrue during the period that the short seller borrows the stock must be paid by the borrower to the lender. Finally, the agreement will also require the borrower to place collateral, equal in value to the borrowed stock, with the lender to mitigate the risk of the shares not being returned. If the value of the shares goes up then the collateral must be increased, hence the infamous “margin call”!

One controversy that arises when funds lend stock is whether the lending fees go to the benefit of the fund manager or to holders of the fund. As it is the holders that make the lending possible, lending fees should be for the benefit of holders, though the fund manager can argue that they would have to increase their management fees, were it not for lending income. Purchasers of funds would be well advised to check their fund managers’ policies on stock lending and income received thereon, and take that into account when considering the acceptability of the manager’s fees.

Note that it is a widespread myth that UK nominee account operators (most brokers and stock trading platforms) lend their clients’ stock. The FCA prohibits this, unless explicit permission is obtained from each client. Stock lending is generally only done by institutions such as funds, pension funds and public portfolio managers.

CFDs and Spread Bets

The second way that a stock can be shorted, which is generally used by individuals wishing to take a short position in a stock, is via a CFD (contract for difference) or spread bet. A fuller explanation of spread bets and CFDs can be found in our other ways to invest in shares article. CFD and spread bet providers will generally not want to take significant market risks themselves, which means that they will aim to run a “balanced book”. This means that if a client takes out a long position, they will generally buy the corresponding stock in the market. However, if they have some clients taking out long positions in a stock and others wishing to short it, they can “net off” one against another. E.g. if one client is long 2,000 shares in a certain stock and another client is short 1,000 shares, the provider only needs to buy a total of 1,000 shares in that stock to ensure that they cannot lose when settling the CFDs or spread bets for those clients. However, if the number of shorts exceeds the number of longs, the provider will generally only accept the excess of short positions if they are able to borrow the stock that is to be shorted, in a similar manner to institutional shorters.

Illegitimate Short-Selling

The above descriptions are legitimate, legal forms of short selling. “Naked shorting” is, by contrast, an illegal method. It involves selling stock that you neither own nor have borrowed: stock that does not exist! An infamous example of this was the Room Service case, where more shares in the company were sold than the total number that actually existed!

How is it possible for this to happen? The answer is that there are two stages in selling (or buying) a share:

Entering into a contract. This is what happens when you instruct a broker or platform to sell a share.
Settlement. This is when the seller has to deliver the shares and the buyer needs to pay for those shares.

Nowadays, settlement is normally on a “T+2” basis, i.e. the buyer and seller should settle two working days after the contract is agreed. However, it is possible to request a longer settlement period, e.g. T+20. Traders, including short-sellers, may use this extended settlement if they intend to complete their trade within the settlement period, i.e. they expect to buy back the shares they sold before settlement is due.

Market makers may also enter into sales contracts when they don’t hold the requisite stock, in the expectation of being able to buy the stock cheaper a little later.

Thus it is possible, for a temporary period, for shares to be traded that the sellers don’t actually hold at the time that the contract is executed. Except for the case of market makers, who have special exemptions, this is not legal and can result in settlement failures, when the seller fails to deliver stock to the buyer when required to do so.

When you use a standard retail platform/broker, such as Hargreaves Lansdown, to trade shares, the settlement process is handled automatically by the platform.

Risks of Short Selling

Short selling is a riskier activity than simply buying stock (“going long”). This because the maximum loss of a holder of stock is the value of their holding (i.e. a 100% loss), whereas the maximum loss for a short seller is unlimited.

E.g. if you buy £100 of a stock at £1/share, your maximum loss is £100, if the underlying company goes bust and the share price goes to zero. OTOH is you short £100 of stock at £1 share and the share prices goes to £3, your loss is £200. The higher the share price goes, the more the short seller loses.

For that reason, short-selling (unless used to hedge a long position) is ALWAYS a trading rather than an investment activity. Whereas an investor may hold a long position indefinitely, a short seller must have an expectation of being able to close (cover) their short position in a reasonable timeframe (or costs of maintaining the position will outweigh the potential gains).

Successful short selling is a difficult activity and a sound strategy is essential. Full members of ShareSoc can watch a Full Member Exclusive Masterclass from November 2020, where experts discuss short selling strategies. One of the risks is that stock prices can spike unexpectedly and, apparently, irrationally. If shorting via CFDs or spread bets, this can result in margin calls or losses if stopped out. Short selling is really for experts only.

Pay Attention to Short Sellers

As explained above, successful short selling is a difficult activity, generally only indulged in successfully by experts.

Holders of a stock (who, obviously, think it has good prospects) often attack short-sellers of that stock (in words, rather than physically, one hopes!). This is a mistake. Those who sell short do so because (like longs) they expect to make a profit. That means that they believe that there are sound reasons why the share price of the stock will fall. For example, this might be due to unsustainable debt levels, a suspicion of fraud, or a belief that a company needs to raise fresh equity in a discounted placing.

Short selling also helps in price discovery, the process by which the underlying value of a share emerges over time – one should remember that in the short term the share price represents the price where there is a balance of buyers and sellers, but in the long term the price tends to move towards the underlying value.

Hence shrewd investors should welcome commentary by short-sellers and consider carefully whether their own thesis for holding a stock may have flaws. Successful investors don’t succumb to confirmation basis and welcome alternative viewpoints that they can consider. That’s not to say that short sellers and their reports are always right – but they are good food for thought.

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