What is Short Sell Trading?

Short sell trading, or short selling as the practice is also known, is an investment strategy where an investor speculates on whether a company’s stock price will fall. If their prediction is successful, the short seller profits from that decline.

Short sellers have been in the public eye recently due to a number of high profile news stories. Notable examples include so-called ‘meme stocks’ like GameStop (GME) and high profile short seller attacks on companies like Lemonade Inc (LMND:US) and Skillz (SKLZ:US)

These events may have made global headlines, however, they do not tell the full story about short sell trading. Short sellers help maintain market liquidity and despite this newfound fame, short sell trading is not a new phenomenon. Since the emergence of markets hedge funds, asset managers have used short positions as a protective hedge against the downside risk of a long position.

With this context in mind, this guide explains more about short sell trading, with an overview of what short sellers do, how they make money, and why short sellers are sometimes seen as a negative influence on markets.

Contents

• What is short sell trading?

• How does short selling work?

• How do short sellers make money?

• Why is short selling banned?

• Conclusion

What is Short Sell Trading?

Short sellers expect a company’s share price to fall. This contrasts with a long position - when an investor expects to profit from a company’s share price increasing in the future.

Instead of the traditional ‘buy low, sell high’ trading strategy, short sellers do the reverse by borrowing a company’s stock. Their intention is to ‘borrow high, sell high, buy low’. The more stock that a short seller borrows, the more money they can potentially gain when the share price falls.

How Does Short Selling Work?

As already mentioned, a short seller borrows a company’s stock. This can be for a predefined period of time as part of a contract, or indefinitely if they have the capital to do so.

These shares are often borrowed from brokers who issue the shares from their own holdings or these brokers transfer shares already bought by other investors as a loan.

In the truest sense of ownership, a short seller doesn’t own shares - hence the term ‘borrowing’ - and one day in the future they might have to return the shares even if they are not ready to.

If the stock price has risen when this event occurs, the short seller loses money. An example of why this might happen is if a company is acquired by another company and the purchase price is higher than what the short seller bought shares at.

Short selling is considered more complicated and riskier than taking on a long position.

As Investopedia explains, “To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open.”

The need to pay interest on the borrowed shares and the fact that a company’s stock price can rise infinitely, means that, in theory, a short seller could incur significant costs for the duration that they are borrowing the stock for and they could face unlimited losses too.

In reality, an infinite rise in a company’s stock price has never happened, but there are cases where short sellers have taken on considerable risk and a company’s share price has risen unexpectedly for a sustained period of time, leading to a squeeze on the short seller.

How Do Short Sellers Make Money?

Here is a scenario.

The short seller trader believes company XYZ is overpriced and its share price will fall soon. This belief could be based on insider transaction data, research, or mere speculation. The trader borrows the stock and ‘sells it forward’ for $5 per share.

Assuming the stock’s price falls to $2 per share in a few days, the trader then rebuys these shares at this price and returns their borrowed shares to the lender, thereby closing the transaction. This earns the trader a profit of $3 per share on this short position.

The price of any stock can only ever drop to $0 per share, limiting the amount of profit that can be made using a short sell.

Is Short Selling Banned?

Some market commentators believe short selling should be banned due to the risk involved and the effect that short selling can have on companies.

While not banned in the United States, short selling is subject to numerous restrictions and under regular scrutiny by financial authorities such as FINRA (the Financial Industry Regulatory Authority) and the SEC (the U.S. Securities and Exchange Commission).

SEC Chairman Jay Clayton has previously defended the SEC’s decision to allow short selling by saying:

“We shouldn’t be banning short-selling. You need to be able to be on the shortside of the market in order to facilitate ordinary market trading.”

During times of market crisis, when stock prices are falling rapidly, regulators have stepped in to either limit or prohibit the use of short selling temporarily until order is restored. During these situations, shorting a large volume of shares can cause the stocks to plummet further and faster, thereby adding to the market’s volatility.

Short sales on downticks (with some narrow exceptions) were initially forbidden too. This rule prevented short selling at successively lower prices, a strategy intended to drive a stock price down artificially.

Conclusion

While some might consider short selling as an unorthodox method for investing, it can be a successful strategy when part of a diverse trading strategy. Short sell trading can be used to ensure an investment portfolio against long-term losses or sudden falls in a company’s share price.

As is the case with any investment decision, diversification is important, as is extensive analysis. This might involve analyzing recent insider transactions or whether a company has been subjected to a short attack.

Follow 2iQ’s blog for updates on the latest short selling attacks as well as regular insider selling reports.