While the term short selling is often associated with day traders and professional traders, seen as a means of speculating, there is a lot more to this activity. The term short selling relates to the practice of borrowing a security, selling into the market with the expectation of buying back lower down. We will cover some variations in a moment, but this best describes short selling in a nutshell.
Uncovered short selling
While you may hear of day traders going "short" on a stock, you will find that this is covered in some shape or form. Short-selling in the UK is regulated by the Short Selling Regulations (SSR), which is basically a UK version of the original EU regulations. This means that day traders and professional traders looking to sell short will need a backup facility to cover their position. This is because they are effectively selling stock they don’t own.
Many day trader accounts will have access to short-selling cover arrangements. These tend to involve:-
• Borrowing stock from a lender
• Agreeing to borrow stock from a lender
• Locate arrangements – which means sufficient stock has been located if required
As you would expect, when borrowing or agreeing to borrow stock, there will be a cost to the client. This will reflect the size and duration of the "short position", which can be open-ended in theory. However, in practice, you will rarely see investors maintain a long-term short position, with day traders literally trading on a daily basis.
Market benefits of short selling
Unfortunately, while day traders and professional traders will recognise the market benefits of short selling, this is not always the case. Many investors see short selling as a simple means of speculating when it actually plays a vital role in stock pricing.
Over exuberant pricing
Occasionally, you will see a stock price spike on speculation or a positive announcement. As buyers pile into the stock, sellers step to the sidelines; this can cause a squeeze which pushes the price to literally unsustainable levels. At this point, the stock may become attractive to a short seller, selling at the top of the spike and buying back when the price consolidates. This is a perfect example of how short selling can help to calibrate share prices.
Enhanced liquidity
While traders looking to take short-term positions in a stock will enhance liquidity, the same could be said of short sellers. Liquidity is an essential element of any investment market, allowing traders to deal in reasonable sizes both on the way in and out. Even though this enhanced liquidity is based on a relatively short timeframe, the constant trading by day traders and professional traders tends to have a long-term positive impact. More stock traded!
Other ways to short-sell stocks and indices
Day traders and longer-term professional traders will often use other short-selling facilities, such as traded options. Whether you sell a call option or buy a put option, the idea is the same; you are looking for the price of the underlying assetto fall. While your purchase will be a one-off cost, selling a call option will involve margin and potentially increased collateral. Specific strategies using this type of investment tool can introduce a degree of leverage, maximising profits but also exposing the trader to potentially significant losses.
Alternatively, fund managers often use the traded options market to protect their underlying portfolios. For example, where a fund manager has a portfolio based on the FTSE 100 and expects some short-term downside, purchasing a put option will offer a degree of protection. In theory, if the market falls, the increase in the value of the put option will offset the decrease in the underlying portfolio's value. Working as a type of insurance policy, this can avoid potentially significant selling costs and timing issues if forced to sell the underlying portfolio.
Summary
While there is much more to short selling, the above content should give you an idea of what it is, how it works and the potential upside and downside. In theory, when shorting a stock, the possible loss is unlimited as the potential price rise is not capped. Where a stock falls, the potential profit is limited to a maximum 100% of the short-selling sale proceeds. Short selling is an interesting option for day tradersand professional traders, enhancing liquidity and trading volumes along the way.