Short selling is a trading technique of selling a borrowed asset from a third party with the intention of purchasing the asset back profitably at a lower price, and returning the identical asset to the third party lender. It is a form of reverse trading.
In finance, this generally involves the short selling of stock, bonds, commodities or derivatives to profit from falling prices. It is a risky practice involving precise timing, and is contrary to traditional investing as historically most markets tend to rise over time.
An investor may short a stock because they believe it is overpriced, the company has poor management, the prospects for the company are weak, or they believe the company’s account may not accurately reflect true business condition.
In order to short a stock, the investor would normally have an account with a broker who would lend the investor the stock which is sourced from another customer with the broker. The investor shorting the stock would be required to have a margin account as collateral for the short sale must be deposited.
A margin account allows the investor to borrow money from the broker which can be used as leverage to purchase stocks, or in this case to cover potential losses for selling short. In taking a long position, the investor purchases a stock with the expectation the price will increase and as a result the investor would have a capital gain.
In theory there is no limit to how high a stock price may rise. If the price decreases and the investor sells, the result would be a capital loss. The risk the investor has on a long position is that the stock goes to zero and all the capital invested is lost, therefore losses are limited.
With a short sale, the gains are limited as the stock may only go as low as zero, but there are no boundaries as to how high the price may rise; therefore, the investor is exposed to unlimited losses.
As a means of limiting losses on short positions, an investor may place a stop-order with their broker.
This is an open order with their broker to purchase the stock and cover the position if the price rises to a certain level, therefore mitigating unlimited liability.
If there are significant short positions in the market and the stock price is rising, the price may even rise further as short sellers scramble to cover their positions and limit losses. This is known as a short squeeze.
Generally seasoned short sellers trade larger companies which are heavily traded. Smaller companies may not have the liquidity, and buying of shares to cover the short position may be difficult when most needed.
Markets certainly do not go up in a straight line and even the best of companies have experienced severe drops in prices.
Being able to profit when stocks go down as well as up is a true testament to the efficiency of markets.
However, it is a very specialised trading strategy that involves expertise and the ability to manage the associated risks.
Anthony Galliano is Chief Executive Officer at Cambodian Investment Management.