The Ups and Downs of Short Selling

No one has a crystal ball, but some savvy investors can make accurate guesses about what the future will hold. What does it mean in the financial world when investors make these accurate guesses – about the bad happening in the future, rather than the good? The answer involves short selling.

What Is Short Selling?

Short selling is a process involving predictions. To short sell, investors research companies and make predictions about which companies’ stock will fall in the near future. They then “borrow” shares of that company’s stock from a broker. They sell the shares on the market at that price.

Then, the price of the share falls. When that happens, the trader buys the shares back and returns them to the broker, at the lower price. When this happens, they make a profit.

For example, let’s say Trader X researches Company Z. They believe Company Z is on the wrong path and will lose value soon. Trader X borrows 1 share of Company Z stock for $100. They sell that 1 share on the market for $100.

Then the price of the share drops to $50. They buy back the share, at $50, after they just sold it for $100, and return it to the broker at the value of $50. Trader X has just made a $50 profit (less commissions and fees) from short selling.

Why is Short Selling Controversial?

In the business world, short selling is considered somewhat controversial. Rafael Nam, Senior Business Editor for NPR, explains that while short-selling is common, “companies obviously hate it when short sellers target them, and short sellers have often been accused of profiting from somebody else’s misery.”

Investors and traders who short sell in general may or may not have a good reputation. In the past, they might have been viewed as greedy people who bet against the economy and put their own financial gain above all else. Sometimes, they were perceived as people who don’t care are about what gets lost when the stock of a company drops in value – as long as they make a gain.

However, there are key advantages to short selling, which is why this controversial practice is legal.

What Are the Pros?

According to Investopedia, short selling can sometimes even be a tool for public good. “Short selling can provide some defense against financial fraud by exposing companies that have fraudulently attempted to inflate their performances.”

How is it that short sellers provide this valuable information more than others? First of all, brokerage houses typically release recommendations to buy stock, not sell. On the other hand, short sellers do their research, and they do it well.

Many short sellers won’t decide to short a stock until they’re as confident as possible that the company is going to lose value. Again, this decision isn’t based on easy-to-find information –  it comes from the short sellers’ own meticulous research.

Another advantage of short selling is that it acts as a reality check for the market. While that friend who points out the flaws in a plan may not be anyone’s favorite, their input is useful – and that’s the role short sellers play. They help tamp down too much bidding by being realistic.

Short sellers have the burden of sharing bad news, but this news is important for the market. According to Amiyatosh Purnanandam, without pessimistic investors who already have questionable stock in their portfolios, and without short sellers, “the stock price will reflect the views of optimistic investors only, potentially creating an unsustainable price bubble.”

That reality check is important, and it’s not the only advantage. Short sellers also provide market liquidity. That means that they make it easy for an asset or security to be converted into cash. Because of these advantages, in recent years more reputable investors have begun to short sell, including hedge funds, quant funds, and others.

What Are the Cons?

However, short selling does have the potential to result in some major disadvantages, mostly for the short seller his or herself. If the short seller is wrong and the price of the stock rises instead of falls, then they’ll have to return it to the broker at a higher price than what they paid for it – losing money.

There are other drawbacks. The natural momentum of the market is to go upwards over a long period of time, so betting on a downward trend in a short period of time is almost counterintuitive. Timing is key for short selling to be successful.

Another disadvantage of short selling is that it is both expensive and prone to changes. To borrow shares in the first place, there are significant costs. Short sellers are also responsible for dividend payments made by the shorted stock.

Changes can also complicate short selling. From time to time, regulators may ban short sales because of market conditions, leading to short sellers having to cover positions at a major loss.

What Do Bears Have To Do With It?

You’ve probably heard the term “bear market” and “bull market.” You can remember the difference by thinking of how bears hibernate during the winter, so a bear market is a market that’s in retreat or decline.

Forbes states that when the S&P 500 or the Dow Jones industrial average fall by at least 20% from a recent high, then there’s a bear market. But what do bear markets have to do with short selling?

Well, during a bear market many investors may want to sell. This will help them access cash and protect their money. However, selling shares has consequences, such as making stock prices fall even lower – which creates an ideal situation for a short seller.

The Illegal Short-Selling Practice

Short-selling can be taken too far. When a trader uses misinformation and a bear market to manipulate stocks, this practice is called “short and distort.” It’s both unethical and illegal, and it involves the trader actively creating and spreading false information to drive down the value of the stock.

The Short-Selling Process Step-By-Step

Now that you know the basics of short selling, you might be interested in how to actually make it happen. Diversifying your portfolio through different techniques can be a smart idea. If you decide to try short selling, your investment portfolio may or may not thank you, depending on your timing.

  1. You need to both open and fund a margin account with an online brokerage account or financial advisor. There are rules for how much money you will need to put into the margin account.
  2. You place a short sale order with either the brokerage or financial advisor.
  3. You must declare it as a short sale.
  4. Your broker will try to borrow the shares.
  5. The “locate” requirement must be followed – meaning that the broker must have reasonable grounds to believe that it’s possible for the security to be borrowed by the deadline.
  6. After the broker has located and borrowed the shares, they will be sold in the market and you will receive any proceeds in your margin account.

GameStop and Short Selling

The GameStop stock craze upended the financial markets. Short sellers were not in a good position during this fascinating coordinated effort by investors in the company’s stock.

Short sellers had performed their research and determined that GameStop’s stock value was going to drop. They borrowed shares, intending to sell them back at a lower price, and profit from the difference.

However, the news changed the game as it became clear that there was a group of motivated investors set on holding onto their GameStop stock. The price of the stock dramatically increased rather than dropping. Because of this, short sellers faced having to sell the borrowed shares at a higher price, meaning they would lose, rather than gain, in the move.

The GameStop scenario is an example of a short squeeze, where investors squeezed the short sellers out of their positions. Short selling is rarely a predictable practice.

The Value of Short Selling

For many years, short selling has had a bad reputation in the market. Short sellers were perceived as pessimistic doubters who wanted companies to fail so that they could profit off their downfall. Investors and the financial world at large viewed short sellers negatively.

However, this doesn’t do justice to the practice of short selling or the investors who take this position. Short sellers are highly motivated to perform their due diligence before they decide to short a stock. If they make the wrong call, their losses could be extreme.

This makes short sellers a force to be feared, which is one motivation driving companies and C-suite executives to be honest in their financial reporting – because if they aren’t, then they could be found out by a short seller, and their reputation will be tarnished.

It’s clear that short selling plays a useful and important role in the financial world, which is why it’s legal. However, it’s not always predictable. There are bans on the practice from time-to-time, which new short sellers should look out for, and a short squeeze could have disastrous consequences.

If you’re looking to become a short seller, you must first have the money to fund a margin account. It’s important to have a good relationship with your brokerage firm or financial advisor if you decide to begin on this investing path.

You may decide to take the path of short selling, or you might settle on traditional investing instead. Whatever your decision ultimately may be, make sure to do your research!

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