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How does short selling work and do funds specialise in it?
I am quite new to investing and my portfolio is invested in shares and funds. I am interested to know how shorting a share works. I don’t really understand it so I’m not willing to try it. Could you explain it and also if there are any funds that attempt to cover this kind of trade?
James Crux, Funds & Investment Trusts Editor replies:
Novice investors should not be tempted by short selling or ‘shorting’ due to the risk of losing more money than they originally put down. It is only suitable for experienced investors, and even then it requires a lot of nerve and money they can afford to lose.
Short selling involves selling a borrowed asset in the hope its price will go down and buying it back later for a profit.
Borrowing the asset comes at a cost, normally a small percentage of the asset’s price. If the share does drop after selling, the short seller buys it back at a lower price and effectively returns it to the lender, thus closing out the bet. The difference between the original sell price and the final buy price is the profit or loss.
When a ‘normal’ investor buys a stock (or ‘goes long’), they stand to lose only the money that they have invested. Yet if an investor short sells, theoretically they could lose an infinite amount of money because technically the price of a share can keep rising forever.
HOW SHORTING WORKS
Let’s say an investor believes hypothetical Company A, trading at £100 per share, is grossly overvalued, or that its shares
will decline when it reports earnings in the future.
The investor borrows 100 shares from a broker while short selling those shares to the market. They go ‘short’ on 100 shares of Company A in the hope the share price will decline and they can close out the bet to make a profit. The initial cost of the trade is £10,000.
One week later, Company A’s price falls to £90 after it announces disappointing earnings. The investor decides to close the short position, so they buy 100 shares of Company A from the open market at £90 each and returns those shares to the broker, making a profit of £10 per share, or a total of £1,000 for the whole transaction (not including commission and interest).
However, if the share price increases to £120 and the investor decides to close the short, they will need to buy stock to cover the 100 shares from the open market at the current price of £120. The loss for this short sale transaction would be £20 per share or a total loss of £2,000, since the shares were bought back at a higher price.
The aforementioned method of short-selling is more common among institutional investors. Retail investors are likely to go for leveraged trading where they trade financial instruments called derivatives. They speculate on the market price rather than borrow shares from a broker.
There are two main ways of placing a short trade via derivatives. The first is spread betting which gives an individual the same outcome as a traditional short-selling position. The second is CFD trading where an individual buys a contract to exchange the difference between the opening and closing price of a stock.
Leveraged trades might be 10:1, which means the investor can control 10 times as many shares as they could with a traditional trade. They have to put up a deposit, such as 10% of the trade, which is the margin. If the price of the stock being shorted goes up by a certain amount, the investor has to provide additional margin cover, so put up more cash to keep the bet open, or they could be forced to close out the position at a loss.
WHY IS IT CONTROVERSIAL?
Short selling has frequently courted controversy, particularly when it involves targeting very weak companies which subsequently go bust. The idea of profiting from the failure of a business when shareholders and creditors lose out financially leaves many ordinary people and investors feeling queasy.
However, shorting by institutional investors can help raise awareness of companies with weak spots. The FCA publishes a list daily showing short positions by big investors.
Short sellers have often done the hard digging to expose corporate fraud, for example. They can be seen as the market detectives, although there is also the potential for individuals to spread lies in order to drive down a share price for their own financial gain.
FUNDS USING THIS STRATEGY
Some investment funds embrace short-selling, such as helping them to hedge risk. They include absolute return funds such as Janus Henderson UK Absolute Return (B5KKCX1) and Jupiter Absolute Return (B5129B3). It is worth noting that absolute return funds in general have a poor track record of late.
Certain investment trusts also have the ability to take short positions to enhance returns; one successful exemplar is the Dan Whitestone-managed BlackRock Throgmorton (THRG).
DO YOU HAVE ANY QUESTIONS ABOUT MARKETS AND INVESTING?
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Please note, we only provide information and we do not provide financial advice. We cannot comment on individual stocks, bonds, investment trusts, ETFs or funds. If you’re unsure please consult a suitably qualified financial adviser.
Short-selling is complex and comes with a high risk of losing money rapidly due to leverage.