This year, the financial markets have seen an increasing interest in short selling. A variety of factors drove this growth, including market volatility, speculation, and sophisticated trading strategies.
This week I will be discussing the concept of short selling. I’ll explain how it works and examine the reasons behind the growing interest in borrowing shares and shorting them.
What is Short Selling?
Short selling is the total number of shares that have been sold short by investors but have not yet been repurchased to close out the short positions. In other words, short interest represents the aggregate quantity of shares that investors are betting will decline in value. A higher short interest or short sell figure indicates that more investors are taking short positions in a particular stock. A lower figure suggests that fewer investors are betting against the stock.
Ok, that’s way too technical – picture this instead.
Imagine you have a friend who collects limited edition sneakers, and you believe the price of one specific sneaker is going to drop soon. You ask to borrow a pair from your friend, promising to give it back later. You then sell the borrowed sneakers to someone else for $200.
A few weeks later, the price of the sneakers does drop. Just like you thought, and now they’re worth only $100. You buy the sneakers back at the lower price and return the pair to your friend. In this process, you made a profit of $100 ($200 from the initial sale minus the $100 to buy them back).
That’s short selling in a nutshell – borrowing something you think will lose value, selling it, and then buying it back at a lower price to return it to the lender, keeping the difference as your profit. The same concept applies to stocks in the financial market.
The Mechanics of Short Selling
To understand short selling, it’s important to first grasp the concept from an execution perspective. Short selling is an investment strategy where an investor borrows shares of a stock from a broker. The investor then sells them in the open market, hoping to buy them back later at a lower price. The difference between the selling price and the repurchase price is the profit for the short seller.
Here’s a step-by-step breakdown of the short selling process:
- The investor opens a margin account with a broker.
- The investor borrows shares from the broker, who typically sources them from other clients’ margin accounts or their own inventory.
- The investor sells the borrowed shares on the open market.
- The investor later repurchases the same number of shares, ideally at a lower price.
- The repurchased shares are returned to the broker, closing the short position.
- If the stock price has fallen during this period, the investor profits from the difference in prices.
Now you know how the short sell works so let us for a moment shift our attention to the risks involve. There are a few so stay with me on this.
Unlimited Loss Potential: In contrast to buying a stock, where your potential loss is limited to the amount you invested, short selling has theoretically unlimited loss potential. If the stock price rises instead of falling, you’ll need to buy back the shares at a higher price, leading to losses. The stock price can keep rising indefinitely, which means your losses can also be unlimited.
Short Squeeze: A short squeeze occurs when a stock with a high short interest starts to rise in price. It forces short sellers to buy back the shares to close their positions, further driving the price up. This can lead to rapid and significant losses for short sellers.
Margin Calls: Short selling typically requires a margin account, where you borrow the shares from your broker. If the stock price rises and the value of your short position declines, your broker may issue a margin call. You will be required to deposit more funds or close out your position. If you fail to meet the margin call, your broker can close the position for you, resulting in a loss.
Dividend Payments: When you short a stock, you’re responsible for paying any dividends that the stock issues while you hold the short position. This can add to your costs and reduce your potential profit.
Limited Availability of Shares: Sometimes, shares of a particular stock may be hard to borrow or unavailable for short selling. This can limit your ability to execute a short sale.
I cannot stress enough how essential it is to understand these risks and carefully evaluate your potential exposure before engaging in short selling. Proper research, risk management, and diversification can help mitigate some of these risks. However, it’s important to recognize that short selling may not be suitable for every investor.
What is this week’s takeaway?
This week I really wanted to focus your attention on the volatility of the markets and how financial professionals and institutions are considering alternative means to navigate these markets.
You have heard me say that I do not believe the markets are providing an attractive risk to return offer on new capital entering the market. That is why for over a year now, mostly all new deposits have been left in cash rather than invested immediately into a bucket of stocks, bonds or alternative investments. Turns out that call was pretty good – cash last year was the second-best performing asset class behind commodities. Check out the chart below:
Source of data: Bloomberg
With short selling interests rising and now built on top of existing risks including interest rate hikes, higher inflation, bank failures in the U.S. and now the possibility of a certain segments of the bond market potentially defaulting on its obligations. I’m taking about the lower credit quality parts of the markets.
Going back to our cash call, managing capital prudently in today’s market requires a different approach or thinking and that is exactly what were doing for our clients.
Have a great weekend!
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