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A guide to short selling
Short selling offers traders and investors another way to potentially make profit – but it’s not for the faint hearted. Despite this, like all trading strategies, you could stand to make some big gains by short trading stocks.
A look at short selling
What is short selling?
There are a couple of different methods of short selling, each basically being the same concept but with a distinct difference.
At its core, shorting a stock is basically betting it will drop in price.
Traditional shorting involves borrowing a stock from a broker and selling it straight away at current market price. You would then wait for the price to decline, then buy the stock back at the new lower market price and return it to the broker.
Any profit made comes from the difference in the initial sell price and the final buy price. If the market falls, you profit from the decline. If it doesn’t, you have to buy the asset back at a higher price and take a loss.
This is a complicated process, and not for inexperienced investors. It can also be difficult to find a broker willing to work with you on such a strategy. It’s also very risky as, theoretically, there is no limit to how low a stock could fall.
As such, many prefer to short derivatives, like a stock CFD, for short selling. In this case, shorting is the act of trading on the price movements of an asset you don’t own via the derivative, in the hope it will lose value, then closing that trade for a profit.
Short selling a derivative
In this scenario, Stock A is trading at $150 per share. You think the stock will fall in price, so you open a short position on the stock using CFDs. You have decided to short sell 100 Stock A CFDs. The price has fallen to $145 per share. If you close your position now, you stand to make $500 worth of profit:
- ($150 – $145) x 100 = $500.
The opposite is true for calculating losses. So, if you have taken a short position, but the share price moves upwards by $5, you would then lose $500.
If you were to short via spread betting, you are placing a bet on which direction the market price will move in. In this case, you think it will fall. Here, you select an amount of currency per point of movement.
So, if you were to go short on a stock at $5 per point, you will gain $5 for every point it moves down. For instance, you think A will fall 20 points at $5 per point. If this happens, you would generate $100 in profit:
- 20 x $5 = $100
Traditional short selling
Stock A is currently trading at $75, but you believe it will fall, so you decided to short it. Your broker lets you borrow 100 shares of Stock A from your broker and sell them at the current market price.
Stock A prices fall considerably over the coming week. They have reached $40. You close your position and buy 100 shares of Stock A from your broker.
To calculate your profit, you would first look at the price of the shares you first borrowed:
- 75 x 100 = $7,500.
Then, you would look at the price you re-bought the shares for:
- 40 x 100 = $4,000
Your profit comes from the difference in the two figures:
- $7,500 – $4,000 = $3,500 = $3,500 profit
Had you been wrong, and the stock increases in value, your risk could have essentially been infinite. Because you only borrowed the stock, the broker is able to ask them back at any time. You would then have to close your position at a price and potentially suffer a major loss.
Shorting & hedging
Many traders go short in order to hedge a position. This is basically holding two positions at the same time in order to offset losses from one position against gains from the other. Traders may take a short position to limit losses incurred from a long position, for example.
If there is a risk that the stock may decline on the long position, you might use a derivative like a CFD to offset that risk. It might not mean you avoid a loss altogether, but it could limit the impact.
But there is still lots of risk associated with shorting to hedge. Asset prices can move in ways you do not expect. If a stock goes up, your potential losses may be unlimited. Another risk to watch for is short squeezing. A short squeeze happens when short sellers try to cover all their positions but end up causing the stock price to rise and making losses potentially much higher.
That’s why, whatever trading strategy you use, it’s very important to know all the risks and try and mitigate them as best you can.
Pros and cons of short trading
- Offer the chance to make a profit on a declining market or asset
- Derivatives like CFDs mean you can go short without owning the underlying asset
- Short selling is inherently risky and can result in major losses
- It can be difficult to get a broker to lend you stocks in order to attempt short trading
Short sellers triumph as Wirecard collapses – but who’s next?
Those shorting Wirecard will have been rubbing their hands with glee after the events of the past few days.
The company, once one of Germany’s tech darlings, last week filed for insolvency after admitting that almost €2 billion in cash missing from its balance sheet likely didn’t exist.
In the space of 11 days the stock price collapsed from just over €100 to as low as €1.15. In the week ending June 26th, Wirecard short sellers made $1.2 billion, with hedge funds accounting for the bulk of that.
Wirecard has been a heavily-shorted stock for a long time, thanks in part to negative coverage by the Financial Times, which has long warned that the company’s finances don’t add up. The stock was so heavily shorted that in February the German financial regulator took the unprecedented step of banning new short positions on Wirecard for an entire month.
Wirecard stock is a fraction of its former value after the 95% drop witnessed over the past 12 days. While hedge funds are still piling in to short the stock, many shorts have already locked in their profits. So what might be the next big target for short sellers?
GSX: Inflated revenues and fake users?
GSX Techedu is a tech company and online education provider focusing on after-school tutoring for primary and secondary school children, as well as courses in foreign language, and professional development amongst others.
The company has been the focus of short sellers for some time now. As of mid-May over a fifth of its publicly traded stock was sold short – 27.3 million shares, worth $815 million at the time. This makes GSX the fourth largest Hong Kong or Chinese equity traded short on US exchanges after Alibaba, Pinduoduo and JD.com.
The company faces claims from Citron Research and Muddy Waters that it has inflated its revenue figures. Citron, which has called GSX “the most blatant Chinese stock fraud since 2011”, has questioned the 431% year-on-year revenue surge reported by GSX in 2019. Additionally, Muddy Waters believes that around three quarters of the company’s reported students are actually bots rather than paid users.
GSX listed on the New York Stock Exchange on June 6th 2019 with an initial offer price of $10.50. The stock is now trading at around $58, and has surged 146% this year.
You can trade this hotly-watched stock on the Marketsx platform.
Tesla shorts down but not out
Tesla founder Elon Musk has been battling against short sellers for a long time. The huge rally seen in the stock price in recent months, while dealing a painful financial blow to short sellers, seems to have only hardened their resolve. Back at the end of January, a stronger than expected earnings report from Tesla saw shorts lose $1.5 billion in a single day. Then, at the beginning of March as the pandemic panic set in, Tesla’s tumble netted shorts $2.8 billion.
Tesla is the most shorted US stock, with the value of its float out on loan rising around $3 billion in the last two months to over $16 billion. That’s around 11% of its publicly available stock. The stock recently rose to trade above $1,000 per share for the first time, helped by resilient demand for its vehicles in China and progress towards a one million mile battery, which could revolutionise the electric vehicle market.
However, shorts believe there is still a large disconnect between where the stock is now and the fundamentals of the company – it went public ten years ago and, while the stock is up over 4,000% since then, Telsa has never delivered a full year of profitability. Shorts are betting that a lot of the recent gains seen in Tesla stock is because of momentum traders, and that the bubble will eventually burst.
Will Hammerson follow Intu into administration?
In the UK, shopping centre owner Hammerson attracted a lot of attention from short sellers during the height of the pandemic panic in March. It’s the most shorted UK stock, with 13% of its publicly traded shares out on loan. A total of nine hedge funds are betting against the stock, as the impact of the lockdown to battle Covid 19 and the prospect of a sluggish reopening hampered by social distancing measures, threatens the outlook for the company.
Rival Intu, owner of some of the UK’s largest shopping centres, entered administration this month. The company was already heavily laden with debt, and the coronavirus pandemic proved to be the final straw.
The fate of Intu shows just why short sellers are interested in Hammerson: as of the end of last week the collapse in its stock price left Intu valued at just £16 million, down from £13 billion in 2006.
While Hammerson raced higher from its mid-May low as its tenants prepared to reopen their stores, the stock has since lost nearly half its value again.
What is short selling a stock?
Short selling, or shorting, is a strategy used by traders in an attempt to profit from falls in the price of a stock. While you can short other assets types, such as FX, commodities, or indices, stocks are the most commonly shorted instrument.
How short selling works
Traditionally, a trader interested in shorting a stock in a company needs to borrow them from someone who already holds them, like a broker. They then sell these shares at the going market price.
If their prediction is correct, and the shares in question do appreciate in value, they are able to repurchase the same quantity of shares that they borrowed for a lower price than they received when they first sold them. They can return the shares to the broker and keep the difference between the original sale price and the repurchase price – minus fees – as profit.
For example, imagine a trader interested in short selling Goldman Sachs borrowed 100 shares on June 5th, 2020, and sold them for $22,200 ($222.00 per share). They then waited until June 26th and bought 100 shares in Goldman Sachs for $19,000 ($190.00 per share). Without fees, they would have made a profit of $3,200.
Thanks to contracts for difference (CFDs), you don’t actually need to borrow or sell a stock in order to short it. You can simply short the CFDs, which are derivatives that track the price of the underlying stock, instead.
Why trade stocks short?
Shorting a stock gives you even more flexibility in how you trade the markets. There are many opportunities that you can take advantage of, as not every business has promising fundamentals or operates in a strong sector.
Wirecard is a perfect example. Although it was considered one of Germany’s leading tech companies, many, including journalists at the Financial Times, raised alarm bells. Wirecard was accused of misreporting its financials, giving the market a false impression of its business.
In June 2020 short sellers were vindicated, when, after having delayed reporting its results as many times as the regulators would permit, Wirecard was forced to admit that nearly €2 billion in cash that was missing from its balance sheet probably did not exist.
The share price collapsed. In the two days following the company’s bid for insolvency, the share price fell almost 100%, and short sellers made a total of $1.2 billion in the week ending June 26th.
Short selling isn’t always a sign traders believe that a business is poorly run or hiding potentially criminal activities. Sometimes they just believe that the market has made an error in how it is valuing the company, and that eventually the price will correct lower to reflect its fair valuation. Or they could be expecting that a wider market downturn will impact the stock in question more than others.
What is a short squeeze?
Short positions lose money when the asset in question rises in price. If something happens to drive an stock significantly higher, short traders may be forced to close their positions to prevent further losses. In order to close a short position, a trader needs to buy the stock that they are shorting. This increases the demand for the stock and pushes the price higher still. More and more short sellers are forced to close their positions because of rising prices, which in turn pushes prices higher and forces out more short sellers.
This is known as a short squeeze.
Using risk management when short selling
Just like with a long position, you can use risk management to lock in profits or limit losses when trading short.
Risk management on a short position works the opposite way around to a long position. So where a stop loss order on a long position would be placed below the entry level of the trade, on a short position your stop loss would be placed above it.
Similarly, your take profit level would be at a lower price than your entry price.