Short selling – why do it and when?

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Short selling – why do it and when?

Most people who have been involved in the trading world in the last few years; are likely to have come across the term “short” or “short selling”. It’s the same “short” that features in the movie “The Big Short”; for example. It’s also the concept that fuelled the recent GameStop incident. What exactly is short selling – and is it prudent for a trader to take it up as a financial strategy? This blog post will investigate “short selling” – why do it and when.

What – and when?

Short selling refers to the practice of “borrowing” a financial instrument and selling it on. The trader in this scenario also then commits to purchasing the instrument again; further down the line; at a lower price; once it has declined in value so that it can be given back to whoever provided the credit. 

There are several different examples of short selling out there. This list of ASX shorted stocks shows Australian shares in order of how frequently they have been shorted recently. A recent example is the GameStop incident that revealed precisely how shorting is used in practice by institutional investors like hedge funds. In the latter instance, hedge funds in the US shorted GameStop’s stock; because they believed that it was going to go down in value over the long term; thanks to the decline of the US Main Street. But a concerted effort on the part of a group of Reddit users put paid to that; meaning that the hedge funds involved faced immediate financial difficulties; as their speculation on GameStop’s decline was tied up in borrowing. 

For many, the time to short is often when an instrument appears to be on a long-term downward trajectory. In the case of GameStop; analysts at the hedge funds in question clearly decided that the evidence pointed towards the sluggishness of the stock’s value; lasting for a significant period rather than being short-lived. 

Rewards and risks

The main advantage of short selling is that it can offer significant financial rewards to the trader; when it goes well. The borrowing aspect means; that traders can place more trades for less value and use debt to plug the shortfall. Although this brings with it more risk; this leverage aspect means; that capital is not as tied up in open positions as it would be if no leverage were present. Hence can be used to open more positions and create a more diversified portfolio. 

As ever, though; the potential rewards have to be considered in the context of the risk, and should only be pursued; if the trader is confident and well-informed. The fact that the practice is based on borrowing means; that the risk becomes double-layered; like “normal” trades. The trader still has to contend with the risk that the opposite effect to the desired one will occur; (so, in the case of shorting; the risk that predicted slump in the market will reverse, and the shorted sector will boom). The borrowing element means; that there is an ever-present risk that money on a losing trade will need to be paid back; even if there is no profit to use to settle the debt; theoretically, there is no cap on the number of losses that a short seller can incur.

Short selling is certainly not a practice that is likely to work for everyone. As the GameStop saga showed, shorting does not always result in a profit. It’s the sort of high-risk, high-reward trading strategy that should not be entered into lightly. For traders; who have the expertise, strategy nous and risk tolerance for taking on such a project, it could prove to be lucrative.

Lara Buck

My name is Lara Buck. A knowledgeable and qualified blogger. Here you can see my skills which gives you brief ideas on understanding all the concepts with different themes.

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