What is short-selling?

by Dan Byrne on Jan 11, 2023

What is short selling

Short-selling is an investment strategy. It relies on the belief (or hope) that a company will become less valuable soon. 

Short-selling is a high-risk/high-reward strategy that can sometimes alarm company leaders unfamiliar with the practice. Because of that, it makes sense to know as much as possible about it. 

Here’s how it works.

What is short selling?

Short-selling (or “shorting”) is when an investor sells securities with intent to repurchase them later when they are expected to cost less. 

The difference becomes a profit.

Does this achieve much profit?

It might sound like it doesn’t. If a person sells and then re-buys securities for a lower price, aren’t they just liquidating part of their own wealth?

This is where the other essential part of short-selling comes in: the securities aren’t usually owned by the investor. 

Instead, the investor borrows them from a broker or equivalent middle-person. So, a simple example of short-selling will ultimately look like this:

  1. The investor acquires the securities on loan.
  2. The investor sells the securities on the open market. 
  3. The securities decline in price. 
  4. The investor repurchases the securities at this reduced price. 
  5. The investor returns the securities to the broker. 
  6. The investor keeps the difference as profit.

Is it always that simple?

Absolutely not. You could book after book on the art of short-selling as it’s a vast topic with many moving parts. 

Short-selling requires professional expertise to accomplish correctly. Investors need to know the risks involved to make a success of it. 

They also need to input some of their own wealth into a “margin account”, which acts as collateral for their borrowing activity. Over time, as markets change, this account may become insufficient to deal with the relevant risk, so investors may need to pump in more money to keep it afloat. This is a “margin call”.

So, what are the advantages and disadvantages of short-selling?

The advantages are:

  • The potential for high profits.
  • The small amount of capital required to start the process. 

The disadvantages are:

  • The losses could be unlimited, at least theoretically.  
  • The necessity of setting up the margin account. 
  • The risk that securities may not decrease in price as hoped.

What should boards and executives know about short-selling?

Short-selling is a gamble, and it involves betting against an organisation’s success. So, does this mean the company is in trouble? 

Usually, it occurs at manageable levels and has no impact on the company’s ability to function. Sometimes, though, this is not the case. 

Danger can arise when the company becomes a short-selling target for investors at the wrong time. 

This can often be the case at the beginning of a recession when a company’s prospects are low, and many investors doubt its long-term performance at once, so they short-sell en masse. 

Meanwhile, the company may be trying to raise more capital to continue functioning, presenting a problem. How can a company raise money when it is vulnerable to short-selling, its share price is dropping, and its reputation diminishes? Few will want to invest in these circumstances.

Can investors use short-selling to target a company?

Yes. It’s known as a short-selling attack and has become enough of a problem that firms like EY have issued guides on handling them

Essentially, short-sellers will borrow a significant portion of shares in an organisation. Then they will orchestrate a targeted, negative PR campaign to drive share prices down. 

While more of a threat to businesses, they can take steps to mitigate their impact.

In summary

Short-selling is a high-risk/high-reward strategy. It involves an investor who borrows securities, sells them, waits for their price to drop and then buys them back. 

Usually, it doesn’t directly threaten a company as far as the board and management are concerned. However, in the right circumstances, short-selling can cause significant headaches.

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