Shorting: what is it and how does it work?

Shorting, short selling or going short. They all refer to the same investment strategy. When an investor opens a short position, they borrow shares and sell them immediately, hoping to buy them back later at a lower price. Their profit is the difference between the sale price and the purchase price. This article takes a deeper look at the different aspects of short selling: what is it, how does it work and what are the benefits and risks?

Going short vs going long

Long selling is the traditional way of investing when you expect the price to rise. You buy shares and sell them at a profit when the price rises. Short selling, however, takes advantage of a fall in price. This is a strategy that allows you to make a profit when the price goes down rather than up.

So how does short selling work? An investor can sell shares that they don't own. They can 'borrow’ them from another investor, but they have to return what they borrowed. They do this by buying back the shares. If the shares have come down in price, they can buy them back for less than what they received when they first sold them and keep the difference as profit.

If all this sounds a bit too abstract, let’s clarify with an example. Suppose you expect a share to fall from 200 euros to 150 euros. You choose to short 10 shares. This means you 'borrow' 10 shares from another investor and you sell them for 200 euros. That gives you 2,000 euros. After that, the price falls and you can buy back the shares at 150 euros each. You pay 1,500 euros for 10 shares. The result is 500 euros in profit.

But what if the price goes up rather than down? In that case, you have to buy back the same shares at a higher price than the price you sold them for and you make a loss.

The benefits and risks of short selling

The example above shows that shorting involves certain risks.

Risk of loss. The potential profit from short selling is limited: the value of a share can only go down to 0. However, in theory the potential loss is infinite as shares can keep on rising and rising. Short sellers therefore can't simply sit back and wait for the rest of the world to agree with them.

Risk of a short squeeze. A short squeeze is a rapid increase in the price of a share that is faster than investors expected. When this happens, shorters have to sell their shares as soon as possible to cut their losses. If they all do this at the same time, the price will rise again and so will demand for shares. This causes a shift in supply and demand dynamics and therefore results in an even greater increase, which in turn increases the effect of the short squeeze even more.

Despite the risks, shorting also has many advantages.

Return. By shorting, you can achieve a return when prices rise and when prices fall.

Speed. Traditional investments are generally rather a slow process. When the stock market falls, the opposite is true: shorting can be done at a much faster pace.

Hedging. Shorting is used to hedge financial risks. For example, you can go short on a share in the same industry that you expect will do worse than the share you are investing in. By balancing your long position with a short position, you hedge (some of) the risk.

Who can benefit from going short?

In practice, short selling is mainly left to the professional investors. This is because it is a little more complicated than traditional investments in shares (going long). There are also more risks involved. You need to know how to work this more advanced strategy. Experience and knowledge are essential, which is why shorting is not top of a novice investor's list.

However, it is possible for private individuals to go short. They can short options, for example, but also leveraged products such as sprinters and turbos. For sprinters, you only pay part of the underlying value. The bank finances the surplus for you and will go short if the price falls. This offers you leverage.

Is short selling (un)ethical?

Short selling is the subject of much debate. On the one hand, short sellers are sometimes vilified as vultures who want companies to fail for their own benefit. On the other hand, short sellers believe that they're doing a useful job.

Investors who are sceptical about short selling can put a stop to the short bets of leveraged funds by buying lots of shares in a certain company. This pushes up the share price significantly and forces the shorters to surrender. This is because they eventually have to buy back the shares that they borrowed and sold. This in turn pushes prices up even further. The result is that a group of small investors can see their profits multiply, while a few short sellers suffer billions in losses.

Short sellers themselves don't see the financial markets as simply a field for growing healthy plants. They also feel that plants who are not bearing any fruit can be weeded out. Shorters see themselves as critics and sceptics. They don't own the shares (and don't want to), but they are an indication that a share may be overvalued or that something isn't right in a particular company. The fall of companies such as Enron, Lehman Brothers and Wirecard, for example, was partly triggered by short sellers who had discovered there was something wrong with their accounts. If you have invested in a share that is heavily shorted, a little extra research certainly wouldn't go amiss.

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