Short Selling: Risks and Rewards

Recently, short sellers have been making a fortune by betting against China in the US and Hong Kong exchanges. In other short-selling news, Taiwan has, in the last three weeks, tightened short-selling regulations three times, fearing global pressures and US rate hikes. So why do some governments seek to curb or prohibit short selling, even when investors can earn higher profits?

Well, let’s learn some more about short-selling.

Short-selling is all about making an investment or trading strategy that speculates on a particular stock or security price. This is an advanced strategy and is clearly meant for some, like experienced traders and investors. If you are a newbie, it is best that you gain a little experience and do a lot of research.

Well, for traders in the stock market, short-sell is used as a form of speculation. Fund managers and investors see it as a tool to hedge against risk in a long position. Regarding speculation, it carries the possibility of heavy risks to the trader and is best suited to advanced traders. On the other hand, hedging is more common and is often used to reduce exposure to risk.

Keeping it simple, you open a position by borrowing shares of an asset, like stocks which you believe are likely to lose value. You then sell these borrowed shares at market price to willing buyers. Before closing your short position, you need to return the borrowed shares. If you intend to earn profits, you need to be willing to bet the underlying asset price will drop further so that you can repurchase them at a lower price. This seems simple enough. But the reality is that if you speculate incorrectly, then the risk of loss can be unlimited since the price of any asset can always be on the rise.

Set up by the Financial Industry Regulatory Authority, Inc. (FINRA) and the Federal Reserve have set minimum values as to the amount a margin account must maintain. This is known as the maintenance margin. If the account’s value drops below the maintenance margin, either more funds need to be added, or the short position has to be sold by the broker.

Short interest ratio (SIR), commonly called the short float, calculates the percentage of shares shorted compared to shares available in the market. A high SIR is generally associated with stocks that are overvalued or falling in price.

Short interest-to-volume ratio is also known among traders as the days-to-cover ratio. The total shares held short are divided by the average daily trading volume of the stock. A high value is a bearish indicator for the stock.

When you decide to short-sell, it comes with the expectation that you are likely to lose more than 100% of your original investment. After all, there is no ceiling on how high a stock can go. Plus, a trader must continue funding the margin account while holding the stocks. And if that is sorted, a trader needs to calculate how much margin interest will eat into their profits. Plus, other costs should be considered, like stock borrowing costs, dividends and other payments.

Even though a company is overvalued, the market could recognize its true worth, resulting in a long time for its stock price to drop. But, on the other hand, you still have to worry about interests, margin calls, etc.

Generally, a short squeeze is likely to occur when the value of a stock rises and to cover their trades, short-sellers try to buy back their position. This creates something similar to a feedback loop and pushes the stock higher as the demand for the stock attracts more buyers. This results in short-sellers buying back more stocks or covering their positions.

As we mentioned about Taiwan’s regulatory intervention earlier, to avoid panic or any selling pressure, regulators can impose short-selling bans on certain sectors. This could lead to a spike in stock prices and is most likely to force short-sellers to cover short positions at huge losses.

If you go buy history, most stocks, in general, will always be on an upward trajectory. So, even when a company is hardly showing any improvements over the years, inflation or if the economy is doing well, then the price of the stock is likely to increase. This only proves when you short against the market, you are betting against it.

For an investor, the main advantage of short-selling is leverage. With transactions being carried out through margin trading, only a certain percentage of the trade is blocked, leaving the investor to make profits or losses on small investments. Plus, it can multiply profit opportunities while adding risk protection to investment portfolios.

For all the controversy, globally, market authorities still permit short-selling as it corrects irrational stock overpricing, prevents the growth of poorly performing stocks, provides liquidity and ensures promoters do not influence prices.

Short-selling may only be for some, and that is why advanced traders are apt for it, as it requires someone with research and experience.