Most of the time investors buy shares in a company because they believe the share price will rise. You buy as low as you can. Then you hope the share price rises. You've probably heard the expression 'buy low, sell high'. But what if you expect a share price to fall? That's where short selling comes in.
I know short selling sounds complicated, but it isn't. In fact, there isn't a lot of difference between short selling and buying shares. If there is one big difference it's this: when you sell a stock short you are SELLING the stock first and BUYING it second. This is the opposite of a normal share transaction where you are BUYING the stock first and SELLING it second.
Let's look at how a hypothetical trade is structured.
Stock: XYZ Ltd
Short Sell at $5.00
Initial target: $4.00
Note how the initial target price is below the current share price. Because we want the share price to fall, our first profit opportunity comes when the share price trades below $5.00. In this example, you expect the price to fall to $4.00. Based on this, you would make a 20% profit, if the price moves as you expect.
If you can't grasp the concept of how you can sell something you don't own, let me give you an understanding by explaining what goes on behind the scenes when you ask your broker to short sell a stock for you.
The following is how a conversation with your broker could sound:
"Hello, this is Big Money Brokers."
"Hello, I would like to place a trade to short sell XYZ Ltd shares, but can you give me the current price first?"
"OK, please can I have your account number?"
"My account number is XXXXXXXX."
"The current price of XYZ Ltd is $5.00. How many shares of XYZ Ltd would you like to short sell?"
"I would like to short sell 1,000 shares of XYZ Ltd at a limit price of $5.00 please."
"OK, I'll need to make sure that we can borrow the stock. Are you able to hold?"
"Yes, that's fine."
At this point the broker needs to check with his back office people to make sure they can borrow shares of XYZ Ltd. Why? Here's where knowing the mechanics of short selling is useful. When you're short selling you don't actually own the shares in order to sell them. So, what do you do?
As you don't own the shares, you'll need to borrow them from someone who does. Your broker will contact his back office to find out if the shares can be borrowed.
The broker's back office will contact a financial institution such as a bank and ask them if they have 1,000 shares of XYZ Ltd they can borrow. If they do they'll send those shares electronically to your broker. Once the broker has received confirmation from his back office that the 1,000 shares of XYZ Ltd have been borrowed the broker can relay that information to you...
"We can borrow 1,000 shares of XYZ Ltd. Would you like to go ahead and short sell 1,000 XYZ Ltd at $5.00?"
"Yes, please go ahead and short sell 1,000 shares of XYZ Ltd at a limit price of $5.00."
The broker will either confirm the trade has been completed immediately or he/she will send you a confirmation later that day.
"I can confirm we have short sold 1,000 shares of XYZ Ltd at $5.00 for a total amount of $5,000 less commission of $50."
"Thank you."
You hang up the phone having completed the trade.
So, what happens next? Well, you now wait for the shares of XYZ Ltd to fall to the initial target price of $4.00.
When this happens you contact your broker to take the profits...
"Hello, this is Big Money Brokers."
"Hello, I have a short position of 1,000 shares of XYZ Ltd; I would like to place an order to buy back the shares to close the trade. Please can you give me the current price?"
"Sure, what is your account number?"
"My account number is XXXXXXXX."
"OK, you have an open short position of 1,000 shares of XYZ Ltd. The current price of XYZ Ltd is $4.00."
"Thank you. Please cover my short position by buying back 1,000 shares of XYZ Ltd at a limit price of $4.00."
"No problem, just confirming you would like me to cover your short position by buying back 1,000 shares of XYZ Ltd at a limit price of $4.00."
"Yes, that's correct."
Your broker will either confirm the trade with you immediately or he/she will send you a confirmation later that day.
"I can confirm we have bought back 1,000 shares of XYZ Ltd at $4.00 for $4,000, plus a commission charge of $50. Your short position is now closed."
"Thank you, goodbye."
That's it, the trade is complete. You sold the shares at $5.00 and then you covered your position by buying back later for $4.00. "Covering" your position just means that you've bought the shares on the market to close the trade. The difference of $1 per share is your profit. You 'sold high' and 'bought low.'
Now, as far as you're concerned the transaction is complete. But for the broker there's one extra step for them.
Remember that the shares you short sold weren't yours. You borrowed them from a bank. Well, when you borrow something you need to give it back eventually.
And that's exactly what your broker will do. After the shares have been bought back through the stock exchange the broker's back office will arrange for the shares to be transferred electronically back to the bank.
Hopefully by now you'll see how simple it is. Short selling just means selling the stock first and then buying it back later. The difference is your profit.
Of course, if the share price goes up after you've short sold then you lose out, as you have to cover your position (buy the shares) at a higher price.
Some investors think short selling is unethical. After all, you're betting that a share price will fall. Does that seem fair?
Of course it does! Short sellers often provide a valuable service. Wall Street and Collins Street are often an enormous hype machine, determined to sell investors stocks even if the companies themselves have doubtful prospects for long-term success.
Short sellers help alert other investors to particular cases where a company is being mismanaged. In recent years, short sellers have been some of the first to uncover fraud at major companies like Enron. And experienced investors often use short selling as a way to hedge their portfolio, which is generally biased toward buy-and-hold (or bullish) investments.
All the best,
Murray Dawes
Technical Analyst, Slipstream Trader
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Related Articles:
- The Practice of Naked Short-selling
- Short-selling of Financial Stocks
- Gold… Selling is the Hardest Part
- Less Gold is Being Sold by European Central Banks
- When the Fix is In
About the Author
Murray began his career on the Sydney Futures Exchange trading floor in 1993 with Swiss Banking Corporation (SBC). He spent a couple of years in the 3 and 10 year bond and option pits before moving on to the Share Price Index (SPI) futures and options pit. From there he became a broker with SBC specialising in SPI futures and options to institutional clients. After leaving SBC Murray continued his career in broking at Bankers Trust Australia.
Then in 2001 Murray moved to Melbourne to work as a hedge fund trader for one of Australia’s wealthiest families. In 2003 he was ready to set up his own firm providing the same proprietary technical trading system to some of Australia’s boutique hedge funds. The success of Murray’s system led to him trading a $10 million account for a high net worth individual. This involved trading Australian and US futures and Australian stocks. Now Murray heads up the technical analysis desk for us passing on to readers some of his experience from 16 years of trading.
Comment by Dan on 27 January 2010:
My grandma always said that you can make more money selling socks than shorts, but that was way back when the winters were still winters. Shorts might be selling better now that summers are hotter. Chairs always sell though, and ideally you match all three and keep them on your porch folio.
I think your point about the moral neutrality of short selling is right. There is no moral system to share trading as far as I can see. If it's speculation, who cares what form it takes. The question is rather whether speculation is good or bad in the first place.
Comment by Justin on 27 January 2010:
What I'd like to know Murray is what is the criteria that brokers use to say what shares can be borrowed, are they held on their own account?
Comment by Ned S on 27 January 2010:
Talking about grandmas, I see that an 82 yo one just got bashed in Rocky - And the financial relevance of that is one very sensible blogger's comment that went along the lines that given Oz is happy enough to have our socks and shorts and chairs made overseas these days, perhaps we could save a few bucks by having our crims processed overseas as well. Think of the crims as the raw material we export to be further refined perhaps? The Brits tried it back in the 1700 and 1800s and it didn't work out all that bad ... IMO.
Maybe Kev should commission a enquiry into how we can save money on government services generally - He's sure to get a few good ideas - To counterbalance Ken Henry's report on how he can pay for more government services generally.
Comment by Richo (the Second) on 27 January 2010:
We insure our houses and our cars. Shorting is a great way to insure a share or superannuation porfolio - its a shame governments try to portray short sellers as evil.
In reality short sellers will only make money when an asset is over-priced - if the asset is not over-priced short sellers will get squeezed out as prices rise - perfect supply and demand in action.
Comment by Ned S on 27 January 2010:
But also remember that just when you'd really most like to be short, government has a tendency to suspend the practice. I actually felt real sorry one US shorty who'd been squawking subprime for years and presumably short the banks that lots teated as a bit of an oddity, that when his payday finally should have come, the banks squawked no fair and government agreed.
Comment by fred on 27 January 2010:
you told the mechanism of the inner broker!
Comment by Matt Fan on 28 January 2010:
The movie"Stock Shock" gives a very easy to understand explanation of short selling and naked short selling. It focuses on investors that saw their SIRI investment go fro 9.00 down to 5 cents/share! You can buy or rent the dvd almost anywhere but it's cheaper at http://www.stockshockmovie.com.
Comment by Stupid on 28 January 2010:
Still don't get it, probably never will
Comment by david_f on 28 January 2010:
This 'financial institution, such as a bank' is remarkably generous, allowing individuals to 'borrow' and short shares in companies they hold, whilst seemingly asking for nothing in return aside from getting their 1000 shares back some time in the future...
Comment by Unpopular Truth on 28 January 2010:
I think everyone would benefit from knowing the difference between short selling and naked short selling too.
Thats when the ethics side of things starts to get hazy.
Normal short selling is GOOD for the market. In fact its less ethical to ban short selling in my opinion.
Comment by denko on 30 January 2010:
Howdy Murray
To add to Unpopular Truth's important point.
Another concern is, in contrast to a long position where the size of your trade is automatically 'capped' by the amount of cash in your broker's account. A short trade does not have this 'automatic' constraint - to regulate each routine trade.
This means that until the short is closed there is a risk the transaction can fail, and thus the seller's 'counter party identity' cloaks the trade until the trade is closed out.
This is not a naked short - but its threat of unregulated failure is as dangerous as trading naked shorts (or bare socks perhaps?)
An explanation here too please; as here too, the ethics side of things start to develop pear shapes, if not that of a paw-paws.
----------------------------------------
The 'cloak of a counter party' differentiates trading through an exchange, where all trades a cleared at the insistence (and underwriting) of the exchange, in distinction to that of an unregulated market.
The sale of commercial paper, is an unregulated market and it is now apparent to be that market where the unsinkable US economy tore its bow to bits as the Good Ship USS struck its devastating ice-berg to initiate the global financial crises.
[This was the breaking of the buck by money market management fund the Reserve Fund, which failed to meet its obligation - "breaking the buck" - and with it, freezing the entire US commercial paper market.
The 'cloak of a third party' in this case Lehmans who on-traded commercial paper for Reserve Fund weighed on every commercial paper trade, and no-one ever thought to weigh or quantify the counter party risk]
Comment by Jim Pettigrove on 30 January 2010:
All of this just reinforces my opinion that all of these additions
[shorts, futures, derivatives etc] are detrimental to the worth of the original share in whatever company as the money has to come from somewhere.
As it appears to have happened last year the dollar had to be replaced somehow so the taxpayer [again] had to subsidise the greed and avarice shown in the "market".
I know that all the so-called money experts will cry me down over this but my theory still stands, if you start with a dollar and everybody starts taking a bit of it very soon it is only fifty cents.
The stock market is very good at finding different ways to get more of that dollar and thereby decreasing the value of the original dollar
Regards
Oldbugger
Comment by High street short on 30 January 2010:
Shorting is a great Idea and should be applied to all commodities in all sectors of society. I'd be straight into the Lambo dealership, pick up a new Murcielargo and go for a cruise. That afternoon I'd hand it back to the salesman with 200km on the clock, worn out tyres, and pocket $30k for my efforts.
"Short sellers help alert other investors to particular cases where a company is being mismanaged "
-By selling their assets out from underneath them, causing them to lose money. I'll bet they're just rushing out to thank Mr Shorty for taking their money.
Shorting provides no safeguard against a bubble, the only thing it does is help the bubble pop rather than deflate. While this correction is useful to day traders, the instability it causes is seriously bad news for the rest of the economy, as we are seeing. If you own something that is overvalued, sell it and if you don't own it, don't buy it. The market regulates itself on a longer time scale without the need for shorting.
Comment by All of the facts on 30 January 2010:
I agree with David, except about the generous part. We know that they are from it. I read somewhere that while you are borrowing the shares, you are charged interest. I guess that is just an oversight.
Comment by ANAIS HUYSMANS on 1 February 2010:
Can you short stocks "alone" tru Commsec for instance as you buy and sell stocks on the net on your own? Or must you always call someone? What is the procedure?
AH
Comment by Lachlan on 1 February 2010:
Its simple just to trade CFDs which track commodities/stocks/bonds etc through a market maker. You can open and close a trade in one minute, done. Of course this becomes like a casino in your own home but so too owning/trading stocks through Commsec,Nab etc etc Lets face it, its all paper casino games. At days end they are all just promises on paper and people always lie at some point. Real wealth is hard assetts such as land and metals etc.
Comment by Lachlan on 1 February 2010:
CFDs go long or short in same time frame.
Comment by Adrian on 26 May 2010:
Interesting and clear explanation. One thing still puzzles me though: what is the benefit to the institution lending the stock to you via the broker? The lender just enabled you to devalue his stock holding by 20%, didn't he? How in the world is that good business for him?
Comment by Coffee Addict on 26 May 2010:
Adrian
My non expert view is that there are invariably two sides to any deal and such deals can either make or lose money for the shorter.
Institutions such as superannuation funds get a fee for "lending" the equities (that contributors "think" they own) to other parties ... and hope to high Heaven that those parties (most often Banks) don't go bust and have their "assets" seized.
cheers