Short selling is a complex yet essential concept in finance and investing. It’s often associated with high-risk strategies and speculative trading, but it also serves as a vital mechanism for market efficiency. Whether you’re an experienced investor or just starting out, understanding short selling is crucial for grasping how financial markets operate

But are the potential benefits of short selling worth the risks? NMTBP explains everything you need to know about short-selling and market manipulation

How does short selling work?

Let’s look at how a short sale of Company X’s stock might work. Currently, the stock is being sold for £100 per share. You believe the stock’s price is primed to fall. You borrow and sell 100 shares for a total sale price of £10,000 from a broker. This step requires a margin account, where you must deposit collateral

Now, let’s assume that your hunch was correct, and the share price for Company X dropped to £80. You buy 100 shares to replace the ones you borrowed for a total cost of £8,000. Excluding interest (and dividends if they apply), your profit would be £2,000 (£10,000 – $£,000 = £2,000)

But suppose you guessed wrong on XYZ, and the price spikes to £120 per share before you finally decide to close your position (buy your replacement shares) and cut your losses. At £120 per share, you’d have to pay £12,000 to replace the 100 borrowed shares, resulting in a £2,000 loss (£10,000 – £12,000 = -£2,000)

The advantages of short-selling

Short selling, despite its risk, offers several advantages for investors, including:

• Potential for high returns: The main advantage of short selling is that it can lead to high returns by profiting on short-term declines in a stock’s value. Using margin in short selling is also attractive to many traders, as it means lower capital requirements and the potential for high profit margins
• Leverage return: Since short-selling is performed using margin, you only contribute a portion of what is needed to make the trade. This may lead to amplified returns. Remember, borrowed funds are essentially loans, so you’ll be responsible for paying back the borrowed amount plus interest
• Enforce fair value prices: Short sellers act against optimistic markets and can identify potentially overvalued assets. In return, this can enforce prices to maintain a fair value and help maintain market health
• Increased liquidity: Short selling increases the overall volume of market trades, contributing to the overall liquidity. Increased liquidity helps encourage trade
• Protect against potential losses: A trader may also decide to go short on stock to hedge against a long position (that is, shares they already own outright). Once the stock’s value drops below a certain price, your long position loses money. However, the profits from your short sale can negate those losses

The risks of Short Selling

While short selling can be profitable, it carries substantial risks:

• Unlimited losses: Unlike traditional stock purchases, where the maximum loss is the amount invested, short selling theoretically involves unlimited losses. If a stock’s price continues to rise instead of falling, the short seller faces potentially limitless losses
• Margin calls: Short sellers are often required to maintain a margin account. If the stock price rises significantly, the broker may issue a margin call, requiring the investor to deposit more funds or close out the position at a loss
• Short squeezes: A short squeeze occurs when a heavily shorted stock’s price rises sharply, forcing short sellers to buy back shares to cover their positions. This buying activity can drive the price even higher, exacerbating losses
• Market Timing: Predicting the timing of a price decline is challenging. Even if an investor accurately predicts a company’s decline, the market might remain irrational longer than the investor can stay solvent

Controversies and challenges of short-selling

Short selling continues to be controversial despite regulatory rules to prevent short sellers from manipulating the market

The main critique of short selling claims that short sellers are predatory investors who unfairly manipulate and take advantage of volatile markets to earn a profit. Short selling can compromise people’s confidence in the market and may negatively impact companies and their investors

Multiple attempts have been made to ban short-selling as a legal practice, but most have been repealed. Temporary bans are more common as a way to help stabilise the economy, such as the one that took place during the 2008 financial crisis

Short selling is a powerful tool in the investor’s arsenal, offering profit potential even in declining markets. However, it comes with high risks and requires careful consideration and expertise. Short selling remains a critical component of the financial markets, whether used for speculation, hedging, or promoting market efficiency. Understanding its mechanics, risks, and regulations is essential for anyone looking to navigate the complex investing world