Short selling is an advanced trading strategy that hypothetically allows investors to profit from the fall in share price. By short selling, you go against the conventional wisdom of investing in companies you expect to grow in value (what’s known as going long).
Unlike holding underlying stock for capital gains or dividends, investors use short-selling because they hope to:
- Profit from overvalued or underperforming companies when shares dip.
- Hedge the portfolio by offsetting losses on long positions in a declining market.
Australian regulators impose restrictions on short sellers because it’s a controversial and high-risk investment approach.
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How Does Short Selling Work?
To start short-selling stocks, an investor:
- Borrows the amount of stock they want to short via a contract with the broker.
- Sells the stock at current market prices in the expectation the price will drop.
- Buys back the same amount of stock at the lower price, and returns it to the broker to cover the borrowed assets.
In theory, the short seller then pockets profits based on the difference in the value of the shares.
Most brokers will allow you to leverage the equity in your trading account to open a short position without a massive initial investment.
(Related: How Traders Use Leverage).
However, you can end up owing a substantial amount if a stock’s value doesn’t decrease.
It takes experience and skill to accurately predict price movements and profit from short selling. You only make a profit if you open a short position before a stock’s price falls, and exit the trade before its value begins to rise again.
Can You Short Stocks On The ASX?
You can short stocks listed on the Australian Securities Exchange (ASX) through some full-service stockbrokers or investment firms, but the services are expensive and only available to wholesale investors and ‘sophisticated’ traders (individuals with a high net worth).
(Related: Is Ethical Investing Right For You?)
You may need to invest a minimum amount in the tens to hundreds of thousands to open a short position via a stockbroker.
- Short selling is legal in Australia, provided you borrow shares you plan to short before placing an order — known as ‘covered’ short selling.
- ‘Naked’ short selling is banned.
Naked refers to shorting stocks without borrowing them first — which increases the risk that the short-seller won’t be able to deliver the shares they owe if prices move up instead of down.
That’s why the Australian Securities and Investments Commission (ASIC) closely monitors short-selling activity across local markets and also reports on short positions daily.
Even if you don’t plan to open short positions yourself, observing short positions of professional investors via market reports can help you with fundamental analysis of your long positions.
Is Short Selling Ethical?
Some see short selling as a moral grey area, as it creates a focus on a company’s demise, which can diminish sentiment among investors or create panic.
For instance, in 2019, ASX-listed company Rural Funds Group was targeted by an overseas activist short-seller who issued a report valuing the company at zero, causing its share price to free fall until the company could address the shocking claim and reassure investors.
(Related: What Is Slippage In Trading?)
What Are Examples Of Short Selling?
Perhaps you agree with some analysts that Fortescue Metals Group (ASX: FMG) is currently overpriced, and you predict a price correction in line with a drop in iron ore prices.
You can open a three-month short position, borrow 100 shares at its current price of around $31 per share, and sell them for $3100.
- If you’re right and the price drops to trade at $25 a share within three months, you can re-purchase the shares for $2500 and return them — making a profit of $600.
- If you bet wrong and the market price of shares increases to $37 per share over the time period, you’ll need to spend $3,700 to re-purchase and return the shares, resulting in a loss of $600.
One of the most famous cases of short-selling stock was immortalised in the Hollywood blockbuster ‘The Big Short’.
The movie is based on a true story of a fund manager who predicted the overvalued housing market that led to the global financial crisis of the mid-2000s, and shorted products underpinned by these risky mortgages.
When the housing market ultimately crashed, the fund made eye-watering profits for its investors.
(Related: What Is Copy Trading?)
What Are The Dangers Of Short Selling?
When you buy a stock you expect to grow in value, you can’t lose more than your initial investment.
Whereas a short sale is a leveraged trade where potential losses hinge on how much the price moves in the wrong direction, and how quickly.
In theory, your losses can be infinite because:
- A stock’s price could continue to rise uninterrupted.
- You might struggle to repurchase enough stock to close your position. Either due to investors holding the stock, or because of competition from other short-sellers (such as during a short squeeze).
Additional drawbacks of using margin for borrowing shares for shorting include:
- You’ll pay interest on the margin amount for as long as your short position stays open.
- If rising stock prices threaten your ability to cover the margin, the broker may issue a margin call —requiring that you add funds to your margin account to keep your position open, which can result in even heavier eventual losses.
What Is A Short Squeeze?
The risk of infinite losses can be compounded by a short squeeze, where investors intentionally buy up and hold a stock to inflate its value.
Short-sellers scrambling to buy back enough shares to close their positions can be confounded by the unavailability of shares and an escalating share price.
A recent famous short squeeze occurred in 2021 when social media users banded together to buy and hold shares of the heavily-shorted US company GameStop — leading to a huge rally in its stock price.
Why Are Investors Attracted To Short Selling?
Investors hope that being able to speculate on falls in an asset’s value opens up more profit-making opportunities.
How Can Retail Investors Start Short-Selling In Australia?
In Australia, short selling is mainly available via full-service brokers or investment firms, typically requiring a minimum of $500,000 to invest.
Options and CFDs are complex and risky investing tactics, so research before attempting any short-selling strategies. Most people lose money — you’re unlikely to be the exception.
Final Thoughts On Short Short Sellers.
Speculating on future falls in stock prices is a risky process. Knowing how to short a stock is one thing —but knowing when to short a stock is much more complicated.
Short sellers require a strong understanding of a company’s fundamentals, which macroeconomic changes will trigger price falls, and when it makes sense to close a position before prices trend upwards again.
Taking short positions is not for the inexperienced or risk-averse investor.