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Created on 13.08.2021

Hedge fund series: Short selling – what is it?

Short selling, going short, shorting – these are terms that have entered the common vocabulary – at least since the sensational GameStop case. But do you know what they mean?

Short selling, short positions, short squeezes – in this series we explain these terms related to stock trading. The series is structured as follows:

The terms “Going short”, “shorting” and “short selling” all describe the same trading method. But what does the “short” in “short selling” mean? In this second article of our hedge fund series, we explain the concept and describe the different types of short selling and what makes them so risky.

What is short selling?

In the context of investment, “short” means that you’re speculating on falling prices and start out by selling something that doesn’t belong to you. Therefore, a short sale takes place when assets are sold on the stock exchange that are not owned by the investor but merely borrowed. Why would someone sell something that doesn’t belong to them, and how is this possible? The investor sells certain stocks at a specific price because they assume that the share price will fall, and they will be able to buy the stocks back later when the stock falls to the “perfect” price.

Basically, short selling is only possible if major shareholders such as pension funds are on the stock exchange and lend their stocks. Why would anyone do this with their stock? Quite simply because, among other things, they can charge a fee for lending their stock. The following example shows how this works in practice:

How do these short sales work?

Imagine you borrow a stock (i.e. a stake in a company) from a bank. You pay the bank a fee of CHF 20 for this. You’re currently able to sell the share on the stock market for CHF 1,000, so that’s exactly what you do, because you believe that the price of the stock will go down – a highly speculative bet.

The stock price now actually does fall, and a few weeks later you buy it back on the stock market for CHF 900. So what is your profit? That’s right: CHF 80 . You can now return the borrowed stock to the bank.

This is how hedge funds and other investors make money by speculating on falling stock prices. It’s also exactly what was going on in the GameStop case, as described in the article “Hedge fund series: What happened in the GameStop case and how are communities influencing stock prices?”.

A distinction is made between covered and uncovered sales

In the case of short sales, a distinction is made between covered and uncovered sales.

Covered short sales

Standard short sales are “covered”, which means that the underlying stock itself is actually lent. This is the case in the example provided above.

Uncovered short sales

More rarely, however, the short seller is not in possession of the underlying stocks (i.e. they have not actually been lent). It is only assumed that the underlying stocks can be sold and bought back at the lower price. This is an “uncovered” (or “naked” ) short sale. These kinds of short sale are twice as speculative because, in addition to the price risk, there is also the risk that the seller does not actually own the stock because they believe they can buy it cheaper by the time of delivery. Uncovered short sales are therefore prohibited in Switzerland as well as in various other countries.

Short sales are processed as spot or forward transactions

Another distinction is made between cash and forward transactions.

Cash transaction

The spot transaction is a normal sales transaction as we know it from everyday life. This is common for short selling. When the transaction is concluded, the seller is obliged to deliver the sold goods – in this case the stocks – within two to three business days.

Forward transactions

In the case of a forward transaction, on the other hand, the delivery time can be freely agreed. A short seller can make the forward purchase before the due date and liquidate the position. But they can also buy the underlying stock and deliver when it is due.

What are the risks of short selling?

Short selling can be problematic. What if the prices rise sharply and the stock in our example suddenly has a value of CHF 1,500? The bank will want the borrowed stock back, and the short seller would make a loss: CHF 500 from the increase in price plus CHF 20 from the loan fee.

Things gets really uncomfortable when the price suddenly rises by more than ten times, as happened in the case of GameStop stocks. Exceptional cases such as GameStop, where speculation caused a sensation, contribute to the negative image of short sales. But even though they have a bad reputation, short selling is not all negative.

Why short selling also has its good sides

Short selling has a dubious reputation, and hedge funds are sometimes referred to as company “destroyers”. But it also has its good sides. Shorting belongs to the financial markets as much as investing, which has a positive effect on market liquidity. For example, pension funds are among the stock lenders, which suggests that the market is becoming more liquid, and they can thus generate additional profits from their long-term investments. It is also legitimate for an investor to bet that a company’s stock price will fall. This can be appropriate, for example, if the quarterly figures do not meet analysts’ expectations or if there are undesirable changes or scandals at management level. Basically, short selling should be left to professional traders.

Hedge fund series: Short selling – what is it? See also the continuation of our hedge fund series.

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