Short Selling (going short)
Short Selling (also known as “going short” or simply “shorting”) is a way of profiting on lower prices. It’s the practice of selling borrowed (from the broker) assets, with the aim to buy them back later and return to the lender. Short sellers assume that they will be able to buy the stock back at a lower price than they sold short and thus profit.
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The short seller profits if the price of the borrowed security goes down – in this situation he is able to buy it back at a lower price. He incurs losses if its price goes up – he has to spend a bigger amount of money for the buyback. There is no limit to the losses that can be incurred while selling short (the price can theoretically rise infinitely), but the potential gain is limited (the price of the stock can fall to zero at the most). Going short may also refer to buying a derivative, where the investor profits from the fall in price of the underlying asset.
Naked Short Selling
Naked short means selling short a security or some other asset without having the asset. For instance, if you sell futures contracts for silver buy you don’t have silver to back up the position. If you had that silver, your losses on the futures contract would be offset by gains on the physical metal. Therefore, this position would be called a hedged (or covered) short futures position. However, if you would sell a futures contract for silver without having silver in the first place, then this position would be purely speculative and since this contract would not be backed by any asset, the position would be called “naked”.
A Brief History of Short Selling
Legend has it that the practice of short selling was invented at the beginning of 17th century by Dutch merchant Isaac Le Maire. It has been a source of controversy and criticism ever since. Shorting East India Company stocks in the 18th century by the London-based banking house Neal, James, Fordyce and Down led to a major crisis, resulting in the collapse of the vast majority of private banks in Scotland and a huge liquidity crisis. Short selling is also responsible for magnifying the Dutch Tulip Crisis.
The term “short” has been used since the middle of the nineteenth century. Short sellers were blamed for the crash of 1929 and this led to the implementation of laws governing short selling. In 1949 a fund that bought some stocks while selling others short hedged some of the market risk – this was the beginning of hedge funds.
What are the risks with short selling?
• No dividend or interest income – contrary to going long, return is taxed only as a capital gain.
• Limited potential gains, unlimited potential losses – the price of a security can decrease at most to zero (100% potential profit, if going short), but it can increase theoretically infinitely (in this case potential loss of going short is unlimited).
• A stockbroker may cover (end) a position if the price of the underlying stock rockets without the knowledge of a client in order to guarantee returning borrowed stock.
• When the stock price rises, some investors who went short decide to cover their positions by buying back stocks thus fueling further price increase.
• A stock may be “hard to borrow” – a stockbroker may charge an additional “hard to borrow” fee for every day the Securities and Exchange Commission (SEC) declares that the stock is “hard to borrow”.
• The stockbroker requires a margin account and charges interest, in order to limit the credit risk.
Costs of Going Short
• Fee for delivering the borrowed stocks – usually it is a commission similar to that of buying a stock.
• All the dividends are paid to the lender from the account of the person going short.
• For some brokers the investor going short does not earn interest on the proceeds from short sale.
Buying a Put Option
A very convenient way of going short is by buying a put option, as it limits the short’s potential loss. It is a contract between two parties to exchange some specified asset at a specified price by (in the case of an American option) or on (in the case of a European option) a specified date. The buyer of the put option has the right, but not the obligation, to sell the asset at this specified price and the seller has to buy this asset, if the buyer sells it. If the spot price at the specified future date is significantly lower than the strike of the option, buyers of the options make a profit – they have the right to sell the asset at a price higher than the market price.Back