What is Short Selling?

There is a myriad of securities strategies out there but few are as inscrutable to the public as short selling. Typically popping up in the news in a dramatic fashion in one way or the other, short selling is often cast as an arcane device only employed by the richest of the wealthiest firms on Wall Street.

This is often the case though, as complex as they can sometimes be, short selling strategies are quite easy to understand from a global perspective. Like many processes on the stock market, it involves the buying and selling of shares of stock but in a way that is different from the normal capital appreciation strategy that is well known to the public.

It's association with wealthy firms such as hedge funds is not an overblown stereotype as short selling can involve large amounts of capital that are often inaccessible to the average investor. We’ll explain how short selling works from a mechanical standpoint as well as reasons why fund managers employ these strategies as part of a matrix of financial structures designed to bring in a secure and stable return on capital despite whatever prevailing economic conditions there may be in the market.

How does Short Selling Work?

In its simplest form, short selling is a bet that short sellers make that the value of a share of stock will decline in the future. Unlike traditional investing where a buyer hopes for the appreciation of the value of a share of stock, a short seller hopes that value goes down. If the value of the share goes up, the short seller loses money. Naturally, you can see how this relationship is the inversion of the traditional stock appreciation dynamic most of us understand.

The Mechanics of Short Selling

What is Short Selling?

While the concept might be quite simple when you look at it as an inverse relationship, the mechanics of it become more complicated. After all, how does a short seller make a bet that the value of a share will decrease? To participate in the normal market, a buyer simply needs to provide a broker with the capital necessary to purchase the shares desired.

In short selling, the broker finds shares of the stock that a short seller wants to short in order for that person to borrow them. Whereas one trader is purchasing shares outright, the other is borrowing them and often for a set amount of time.

During that period of time, if the value of the shares increase, the short seller owes the original owner of the shares the difference between the purchase price and the new price. If the share values decrease, as is hoped by the short seller, then he makes money off of the difference between the price at which he borrowed them and their current value. Herein lies the somewhat arcane and terrifying nature of short selling that the media often loves to hype.

The Theoretically Unlimited Value of a Share of Stock

In traditional stock purchases, the total value of a share of stock is theoretically unlimited or, in other words, one share could equal the sum of all of the capital currently on the market. This theoretically unlimited value of a single share of stock means that, where short selling is concerned, the potential losses for a short seller are similarly unlimited.

When a traditional shareholder loses out on the entirety of their investment, their loss is limited to the capital outlay already made. But short sellers have to cough up the difference between their bet and the current price. This number can grow exponentially large because of this theoretically unlimited ceiling to a share’s value.

This is why it is a practice only employed by those with advanced knowledge of market dynamics and/or very deep pockets.

Risk Reward Ratio

The potential rewards from a smart short selling strategy are enormous, but so are the potential downfalls. That said, given the massive risks associated with it, why would so many staid firms on Wall Street engage in this kind of activity?

Like many financial products and services on the market, short selling meets a consumer need and this is one centered around robust, stable returns on invested capital. Because of the volatility of the market and the sheer impossibility of predicting returns, many investors seek a hedge against capital loss through novel investment vehicles among which short selling plays a prominent role.

Hedging Strategies Against Capital Loss

Through the process of simultaneously betting that the value of a share will go up or down, a trader can help ensure a steady return on capital no matter what movements may be occurring in the market. As can be discerned from a simple glance at this function, this use of short selling is extremely sophisticated and often involves loss harvesting for tax advantages, among other things.

When taken in this context, it is also easy to see how short selling can be tailored to accommodate various investment risk strategies from highly volatile, speculative strategies, to simple capital preservation strategies that boast modest though consistent returns year in, year out. Just as diversification in investments is important, so, too, the thinking goes, is diversification in investment strategies.

Yet, just as every product on the market is not targeted at a general audience, so, too, are many financial products specialized for certain niches that are capable of financing them.

How Short Selling Functions in the Market

At first glance, it might seem as though short selling is nothing more than a speculative aspect of the market that doesn’t seem to serve any purpose other than indicating that big money is betting against one stock or the other.

This is often true, however, these bets aren’t placed haphazardly. For the reasons listed above, short sellers often conduct very in-depth research on their “target” companies before shorting them. Typically these include beleaguered firms in waning industries and the like but can also include big-name brands that, for one reason or the other, are being questioned by short sellers and their research.

A more recent example of a big name brand getting targeted by short sellers yet emerging from the ordeal is the battle between investor Bill Ackman and Herbalife.

Activist Investing and Short Selling

Ultimately, Ackman paid out huge sums of money because Herbalife, contrary to his bet, actually increased in value yet the whole ordeal has become one of many touchstones in the short-selling community for how media and business practices can factor into the calculus of a short sell.

People who advocate for short selling in this kind of functional space do so as “activist investors” or those who want to improve the company by highlighting its deficiencies or remove it from the market entirely for those same reasons.

In the case of Herbalife, Ackman wasn’t just out to make money, but he also claimed that he wanted to highlight what he argued were predatory business practices that made the firm associated with them unsustainable over the long term.

Whether to run the company out of business, thus providing himself with maximum returns, or to change its practices while reaping the benefits of a temporary dip in value, neither purpose actually matters to the mechanics of short selling (or Ackman) but merely serve as a reason often cited for supporting short selling’s continued existence in the marketplace.

Pros of Short Selling as an Investment Strategy

Short Selling is useful.

Some of the pros of short selling, in brief, include huge returns on capital as well as an initially small outlay to achieve that. You can also leverage other investments in short selling as well as use it as a strategy against losses.

Cons of Short Selling as an Investment Strategy

Some of the cons of short selling include the potential for unlimited losses if the value of the stock goes up. If stock’s value starts to rise exponentially, short sellers can get caught in what is called a “short squeeze” wherein they have to post up large sums of money to keep their position.

Because of these dynamics, margin accounts are often required to participate in short selling and margin interest can become a factor in your ultimate return on investment. Timing also becomes a huge factor in short selling meaning that an investor needs to be able to predict when the value of a share will fall.

For the average investor, this kind of foresight is hard to achieve, not to mention the kind of research required to lead to such an estimation. Aside from the borrowing costs associated with short selling, which can be significant, short sellers are also responsible for any dividends the borrowed shares pay out as well as any share splits or bonuses that might occur while being held in a short.

Beginning Investors and Short Selling

While short selling provides a range of tangible benefits to traders and deep-pocketed individuals, the risks often outweigh these advantages and pose a substantial threat not only to the trader’s capital but also their total asset mix.

Investors that are looking for a hedge against losses but who do not have substantial capital or access to sophisticated financial firms and their trading expertise can utilize exchange-traded funds (ETFs) or index funds to offset losses in capital.

This is predicated on the general notion that the values of stocks will continue to climb into the future thus making whole sector bets a wise long-term decision for investors seeking steady returns on invested capital.