Shortselling simplified – 4 examples
- Von Thomas
A short sale is a stock trading technique offered by a broker that is either not understood or misunderstood by the general public.
In the following article, we explain in an easily understandable way what a short sale is all about, how a short sale works in detail with a broker, why the technique of a short sale can make sense and why a short sale is by no means to be demonized from the outset.
What does shortselling mean?
Normally, one buys and holds shares of companies for which one sees a rosy future and therefore assumes a positive price development.
In the case of a short sale, the assumption is now exactly the opposite.
The market participant assumes that the share price of the company will fall.
However, he does not want to wait until the quotations are in the cellar and then buy cheaply and bet on rising prices from then on, but he wants to profit directly from the falling prices.
And there are several ways to do this, as we will read later.
Going long vs. going short
We also talk about short selling in my educational offerings for traders. Now click the image below to learn more about short selling and sensible trading.
Professionals in particular hardly ever use the term short selling.
And the classic private investor does not come into contact with short selling.
Rather, one speaks of going long or going long when one bets on rising prices. Conversely, one says short or go short when one bets on short selling.
The origin of short selling
The Dutch trader Isaac Le Maire is considered the world’s first short seller.
In 1602, Isaac Le Maire invested more than 80,000 guilders in the Dutch East India Company. Since this company did not pay dividends in 1609 due to various disputes, Le Maire decided to sell his shares.
However, he sold more than he owned and made a lot of money from it, which eventually led to a temporary ban on short selling, but this was lifted again a few years later and from then on established itself as a permissible trading technique.
How does short selling work?
How do you sell something you don’t even own? Actually, you do it the same way you would do it with any other good in your daily life.
A trader “borrows” the security from someone who owns it (and currently does not want to sell it), pays the owner a small premium for borrowing (interest).
Then one immediately sells the stock on the stock exchange and later returns it to the person who borrowed it. This means for short sales: the time of the sale is crucial.
Namely, when one sees no more potential for further falling quotations. If the stock has fallen between borrowing and giving it back, you have made money.
Otherwise, because the timing of the sale was badly chosen, you will probably have to cover yourself with a loss through your broker.
all information about the procedure summarized
- borrow from the owner
- sell on the stock exchange
- wait for price change
- cover/buy back on the stock exchange
- return to the actual owner & pay premium
Short Squeez
Squeez means to squeeze and this phenomenon can be understood in a similar way.
A short squeez occurs when a certain financial instrument, which was shorted by a particularly large number of market participants, is increasingly bought back (covered) and there is then a sudden sharp rise in price. This puts even more pressure on the short sellers and they have to liquidate their positions (at a loss).
The cause of the rise can have several reasons and ultimately is not relevant.
Rather, what matters is that short sellers become nervous when prices rise sharply, during which they naturally lose money and thus important capital, and so they have to buy back securities on the market urgently and sometimes at any price to prevent further losses in trading.
In doing so, they increase demand, which can lead to a vicious circle, because in doing so, traders only drive prices up further and faster. So a short squeeze is the nightmare of short selling. So you see: short selling is something you have to master.
In the course of the Great Depression and the stock market crisis of 1929, it was decided that speculating on falling prices should be made more difficult for security holders.
Speculating on falling prices was therefore prohibited when a share was about to fall.
Or to put it more precisely: the last stock exchange transaction (= tick) of a share had to be above the price immediately before in order to be allowed to go short.
This rule was repealed in the U.S. in 2007, and experts are still arguing today about whether the repeal of this rule was partly responsible for the massive drop in share prices in the course of the financial crisis. In any case, short selling has become more difficult. Selling them is often not worthwhile (anymore).
Is a short sale permitted?
In the course of the financial crisis in 2008 and 2009, the aim was to stabilize the markets and a temporary ban was imposed on short selling.
But the ban was overturned again in 2010.
However, not all countries participated in this measure at the time.
In 2012, the regulations were tightened again, for example by introducing reporting requirements if a short sale exceeds a certain amount. This information was intended to prevent non-transparent dealings.
Furthermore, the German Bafin, for example, has banned uncovered short selling at German companies.
What is an uncovered or naked short sale?
As we know from above, the seller borrows the underlying from someone who owns it to return it at a later date at a profit.
This would be theoretically possible, since one has two days to borrow shares before shorting them.
The problem for short selling is obvious: you can make so many more sales than you own securities, and thus you are taking a high risk. So uncovered short sales are high risk.
For this reason, this type of short selling has been banned in the EU in the meantime. The short sale of shares and the like is thus severely restricted.
Definition of uncovered or naked short selling
An uncovered short sale is when you sell a financial instrument before you have borrowed it
Which financial products can be used to perform a short sale?
There are numerous financial products that brokers offer today that can be used to make money when prices fall. Thus, short selling is spoiled for choice and profit can be made with several products.
For example, futures allow you to speculate on falling quotes. This means that a Dax or a Dow Jones, for example, can also be sold short.
But not only futures are suitable for short selling, also numerous synthetic products such as CFDs are suitable for this purpose. In the following we will clarify which asset classes should be on the watch list.
Product examples and information summarized – bet on falling prices with
- Shares
- Futures
- ETFs
- CFDs (not allowed in the US)
- Options (as writer)
- Warrants
- Certificates (not allowed in the US)
- Forex (within the trading of currency pairs)
- and much more
In which asset classes can you do a short sale?
Short selling is basically possible for all asset classes.
You can short stock indices, commodities, cryptocurrencies, interest rates, but also stocks directly. A short sale is therefore extremely flexible.
With currencies such as the euro, you can also bet on falling prices, but currencies are almost always traded in the form of currency pairs at a broker.
For example EUR/USD (US Dollar) or EUR/CHF (Swiss Franc).
Of course, this also applies to all other world currencies such as the Japanese yen, the British pound or the Swiss franc, to list three particularly important currencies.S
Bet on falling prices without actually short selling - is that possible?
Even without direct short selling, you can bet on falling prices to optimize profits.
For example, there are certificates or warrants that allow you to earn money when prices fall.
However, these products are not permitted for trading in all countries. The short seller must therefore be careful which securities he chooses and which stock exchanges he trades on.
Is it possible to short stocks?
Yes, the short seller can also enter directly into shares as part of a short position.
In order to profit from falling prices, it is not necessary to use high-risk financial products such as warrants or CFDs.
Also the share itself can be shortened with many brokers. But be careful: every short position must be watched intensively.
In practice, traders who want to bet on falling prices and thus on short positions do not even notice the process of borrowing and returning.
Especially not when a trader shorts small numbers of shares with his broker.
He simply clicks on “sell” in the trading platform of his broker instead of “buy” and since he has not yet had the share in his portfolio, he is then positioned short and has a negative share position in the portfolio.
Note: in the hedge fund industry, which also likes to use this technique, real deals are made when shorting, which are also partly done by telephone. The numbers of units are much higher there and it is often individual agreements between large market participants, which can then also fuel the aforementioned short squeeze. But this is an area in which a private short seller has little insight.
Short sale and dividends
On the dividend record date, shares are traded ex-dividend and normally the price falls by exactly that percentage of the distribution.
Therefore, one could now assume that going short over such a date is a lucrative trading technique.
However, this is not necessarily the case, because if you are short over a dividend record date, you profit from the price decline, but you have to reimburse the short seller – the actual owner from whom you borrowed the securities – for this dividend. The results are therefore mostly neutral in such a case and the profit is equalized by the dividend to be repaid.
The influence on the market - trading stop
Sometimes stock prices fall quite sharply. To limit the risk, safety mechanisms and restrictions have been built in. This is called a trading halt, which is applied in certain situations on some stock exchanges, such as the Nasdaq, when an individual stock falls by a set percentage over a certain period of time.
This is the background knowledge a short seller should have before going short.
Note: such a trading halt can also be imposed several times a day.
This is to ensure that a stock cannot plummet in a matter of minutes.
Furthermore, large institutions such as insurance companies or pension funds are not allowed to go short at all, in contrast to a private trader, and it is precisely these institutions that move the markets with their billions.
Private investors and, surprisingly, hedge funds play a much smaller role in terms of trading volume than is often assumed.
So, since many institutions are not allowed to go short at all, the following is important for understanding short selling in the context of falling markets. This statement is fundamental stock market knowledge.
Stocks only fall particularly sharply when all the major market participants who were betting on rising prices throw their securities onto the market (sell) and go into cash. Prices do not fall because “everyone suddenly goes short”.
Is speculation on falling prices dangerous for the investor?
Short selling is still considered dangerous. Here, too, one should stick to facts. By the way, there is also a short blog post in English on the subject of facts & trading on “the.street” the large financial and trading portal of Jim Cramer. Learn more here
So is this true about dangerous short selling?
Theoretically yes, because a stock, if you have bought it, can fall to a maximum of zero and thus become worthless.
So in the worst case, you lose your investment completely.
If you are short, however, the share can increase in value several times, which increases the risk of loss to several hundred percent.
In practice, this danger exists at most if one shorts shares of small second-line stocks, or if one bets on individual events such as company takeovers or bad news, where things can then go (very) wrong.
If, on the other hand, you stick to blue chips, i.e. the large public companies of any country, this theoretically existing risk of several 100% loss on a single short sale is practically zero.
Or in other words – the risk of loss is not higher than if you go long.
Or have you often heard of a share from the Dax or Dow Jones that has risen by more than 100% from one day to the next?
Going short to reduce risk - does it really work?
At the broker bet on falling prices, and this may now be surprising, reduce the risk of an investment.
How does it work?
Let’s assume that we have a financial product in front of us that invests in the best 10 stocks from the US American Dow Jones Index, however we define “the best 10” now.
Each stock is allocated 10% of the available capital and thus one is 100% long.
If there is now a broad market collapse, the 10 shares will also significantly lose value. But now you can reduce the risk with a short trade on the whole market.
One option would be, for example, to allocate only 80% of the money to these 10 shares and put the remaining 20% in a short ETF.
Or to short a long ETF. If the overall market loses and therefore probably all 10 stocks, then at least the ETF gains value and you can mitigate the losses somewhat.
Experts speak here of hedging, and hedging means to secure. It is obvious that the 20% that are in the ETF lose value when prices rise.
An important stock market rule is therefore: Hedging costs performance in most market phases, because the stock markets tend to go up.
Another detail option of the example given earlier is to put 100% in the 10 stocks and invest 20% via leverage in an ETF to hedge.
You then leverage the account, which is long considered a high risk investment, but in this case two supposedly very dangerous things significantly reduce the risk in trading.
Short sale
Leverage
One must therefore ask or look carefully when criticizing certain trading techniques.
Safeguarding or hedging the deposit
Short selling on individual stocks can be a good strategy here and there.
However, it is by no means suitable for hedging a portfolio.
Many investors think that if they pursue a strategy that goes short and long, they are protected in the event of a stock market crash.
But they forget that a (possible) short trade in a single stock does not reduce the risk.
The reason for a possible short trade is that a strategy that relies partly on rising and partly on short selling in different stocks does not necessarily have to have long and short trades in the portfolio at the same time.
So what is the use of having a strategy that theoretically also goes short if there are no short trades in the portfolio just before a crahs?
So you are long only and the markets fall massively.
Then it is of little help that one would also make short trades if there are currently none.
Another example: if things go really badly, for example, you are long on 8 stocks and short on 2 stocks at the same time.
The market crashes.
The 8 long trades lose massively in value.
But the two stocks you are short on go up and you lose again.
Such a situation is not constructed but quite conceivable in practice, because in a crash there can always be stocks or entire securities sectors (pharmaceuticals, commodities, defense stocks, utilities, etc.) that resist the downward pressure.
Short strategies used for hedging should therefore always be applied to the overall market from which the long stock positions of the strategy originate. So the goal here is not to make more profit but to reduce risks, for example of the stock trading.
Short Selling - FAQs
- Is it possible to short sell via CFD trading? Yes But we prefer stocks as securities. Because CFDs are not listed on the stock exchange. With all the associated problems for the short seller.
- What is the meaning of uncovered short selling? Uncovered short selling is prohibited in many places. A private short seller should avoid such practices in any case.
- Which instruments are suitable for short selling? Short selling can be done with stocks or within CFD trading. As mentioned above, we prefer stocks.
- Can the short seller make more profit? Not more profit but usually the quotes of the securities fall faster than they rise. So any profit can be made more quickly if you manage the risks of selling well.
The bottom line on short sales
A short sale can be useful if you do it right as a trader. The market price risk can be reduced by short sellers and profits are possible. Please also pay attention to the risks.
In practice, the risk to capital is not much higher than when prices are rising, especially if you are targeting blue chips.
Short sales also do not trigger a stock market crash.
They may temporarily intensify it, but on the other hand they also contribute to the stability of the markets and ensure liquidity in both trading directions. Short selling therefore makes sense in trading and should therefore be evaluated neutrally and not emotionally in advance.
