How does short-selling work?

Whether you’re a seasoned investor or just starting out, you probably have heard this term before. What you may not know is what short-selling actually means, and more specifically, how short-selling works. There are a lot of moving parts to it, but when you break it down piece by piece — which we’ll do here — you’ll get a better sense of what it is and why it’s such a hot topic right now. 

How does short-selling work in practice?

Short-selling — or shorting a stock, as it’s often described — is essentially a calculated risk where an investor borrows stock from a broker in order to resell it to another investor at market value. The goal for the borrower is to resell that stock at a profit. But in order for that to happen, the stock has to go down in price so the original buyer can buy it back again — which is called covering — at that lower price and also repay the broker. If the stock value does go down, the buyer makes money from what’s left over after returning the borrowed shares to their broker. 

In summary, for short-selling to be successful, it’s premised under the assumption that a stock will diminish in value when the time comes to buy it again. It’s a very high risk, high reward approach to trading.

Still confused? The Balance has a great breakdown as to how the process works and the different parties involved, replete with a chart and the point-by-point components to a typical transaction. It usually involves at least three parties:

  • The broker (who owns and lends stock).
  • The short seller (who seeks to sell the stock they project will lose value later on).
  • The “market” (other stock buyers).

1. The short seller borrows stock from the broker that they intend to resell.

2. The short seller finds a buyer and sells all of their shares to that investor at market price, valued at $400 ($20 x 20 shares = $400).

3. The share prices for the stocks sold decrease in value — as the short seller anticipated — by $5, reaching $15 per share.

4. The short seller learns of this and buys back the same number of shares sold — presumably from a different seller — which comes to $300 ($15 x 20 shares = $300).

5. The short seller then compensates the broker for the amount owed and nets $100 by virtue of the stock price dropping.

Bottom line: The ability for the short seller to make money in this deal hinges on diminished valuation. But there’s no guarantee that this will happen; it’s all speculation. In fact, it’s possible that the stock or security prices go in the opposite direction — higher. Because the short seller has an obligation to repay what’s owed to the broker — which can only be done by buying the stock back — the investor could wind up losing money once settling the debt with the lender. 

What are the potential advantages to short-selling?

There are a lot of variables and unknowns that can turn out the wrong way, which is part of the reason why, at Magma, we tend to avoid this approach altogether. You may understand why in the upcoming section regarding the pros and cons to shorting stock. For the most part, there are far too many downsides than upsides. 

Advantage No. 1: Potential for profit

While short selling can be complex, the payoff is straightforward: the ability to make money. If you as an investor guess correctly and a stock or security loses value after you already sold it, you’re left with the difference in price upon repaying your broker. The lower the price goes, the larger the profit you make with the repurchase. It’s the converse of “buy low, sell high,” only with more parts to it since there is more than one buy/sell process. 

Advantage No. 2: Generally requires a modest investment

Depending on what stock or security you’re purchasing — as well as the number of shares — short-selling doesn’t necessarily require a significant amount of capital to take part in. As noted by The Balance, the only obligation an investor has is repaying their broker the original shares borrowed, plus applicable fees and interest for borrowing. There’s no minimum or maximum as to the number of shares you have to buy to participate (again, depending on the broker you’re using and the stock you’re interested in).

Advantage No. 3: Serves as hedge for long positions

The counterbalance to short positions, long positions are those where you anticipate prices will rise in the future. If that doesn’t happen, short-selling can serve as a hedge for long positions in the event prices do not go up. Shorts are a counterbalance and help to guard against market volatility.

Disadvantage No. 1: Loss potential is unlimited

The single-most influential factor on profiting from short-selling is the price of the stock declining. You may have all the reasons in the world as to why share prices will go down (e.g., a poor quarterly earnings report, sagging consumer sentiment, a bad monthly jobs report, etc.), but stocks are by their very nature subject to fluctuation. If the value doesn’t diminish as you anticipated, you could lose out on your initial investment — and then some. Plus, since shares are sold on a per-share basis, the cost to you is multiplied severalfold. This means if you sold $400 worth of stock at $20 per share, and the value goes up tenfold — to $2,000 — you’d be in the red to the tune of $1,600 since you have to buy back the stock to repay your broker.

This is ultimately what happened with the GameStop controversy that erupted earlier this year. As was widely reported at the time, hedge funds anticipated that the stock prices would drop, but just the opposite happened: Prices rose more than 1,700% in a single week, according to VOA News. 

Of course, short-selling as a practice goes back long before GameStop. As Quartz reported, its history started back in 17th-century Netherlands. The brainchild of Isaac Le Maire, founder of the United East India Company, short-selling was a tactic Maire used to drive down the price of his company’s stock after a falling out with some of the business’ co-owners.

However, once Maire’s former colleagues got wind of his strategy, they sought to ban the practice and called on the Dutch government to take swift action. It did, making short-selling illegal nationwide. Which takes us to another con of short-selling.

Disadvantage No. 2: Highly regulated

Red tape is another reason why short-selling may be more of a hindrance than a help as an investment strategy. One of the rules that govern short-selling, which was established by the SEC in 2010, precludes the activity from taking place any further in a given trading day if the price for the stock in question goes down by more than 10%. It’s called the “Alternative Uptick Rule, which is designed to reduce or restrain major market volatility. This is one of several rules that may make you think twice about pursuing it. 

Disadvantage No. 3: Unlimited downside risk

Perhaps the biggest problem with short-selling is just how much you could lose in money: There’s no floor. As referenced by The Motley Fool, it’s the exact opposite of what happens when you buy a stock with the intention to keep it. In that case, there’s unlimited potential as to how high the price could go, and how much you could make upon selling it when the time feels right. The sky is the limit. 

While you stand to lose money by buying or short-selling, you could lose much more with the latter approach than the former. 

Disadvantage No. 4: Losses can adversely affect the entire stock market

Hedge fund managers literally lost billions of dollars by betting GameStop prices would drop when they didn’t. The amounts were so staggering that the New York Stock Exchange at one point halted trading to prevent a chain reaction on other stocks and restore stability. 

Additionally, that can be wrapped up in short-selling, that money lost by hedge funds and other investors can have far-reaching effects, well beyond Wall Street. For example, some financial experts and economists attribute the housing crisis that occurred in 2008 to short-selling gone wrong, touched off by the bankruptcy of investment banking company Bear Stearns.  

From the sordid history of short-selling to the fact that success with it largely hinges on guessing correctly, this investment strategy is fraught with risk that could backfire in the long run. At Magma, we don’t short individual stocks. Instead, Magma Capital Funds leverages a systematic investment strategy for each of our clients that is designed to respond to volatility, but in a way that safely and responsibly allocates between asset classes to deliver consistent, healthy returns. For more information on our approach or any of our services, please don’t hesitate to contact us today. 


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