How Short Selling Works (Finance)
In finance, short selling or just “shorting” is betting that something will fall in price.
It could be a bond, a futures contract, currencies, shares or another asset that can be traded quickly.
How does shorting work?
Imagine you’re an investor and you think shares of The Rask Group are overpriced.
You decide to short it.
You find a big investment firm or broker who has 100 shares. These shares are priced at $1 each. But what’s important to remember is the number of shares. 100.
You say to the broker, “I would like to borrow your shares”.
The broker says, “Ok. But I want them returned in 3 months with 5% in interest.”
You agree to the deal and take the 100 shares.
Then, you sell them on the sharemarket for $100. That is, for $1 each.
In the next couple of months bad news surfaces about The Rask Group’s CEO and the shares fall from $1 to 20 cents.
Using the $100 you had from the earlier sale you buy back the 100 shares. This time, however, you can buy 100 shares for just $20, or 20 cents each.
You can now take your 100 shares back to the broker or investment firm as you agreed. They’re now worth $20. But that doesn’t matter to them. The agreement was for the 100 shares which you borrowed.
You also owe the broker $5 in interest. That’s 5% of $100.
So did you make money from short selling?
Let’s focus on the cash flow for the investor.
It didn’t cost us anything to get into the contract upfront but we sold the shares for $100. So that’s $100 in our pocket.
Then we had to buy back the shares for $20 and pay the broker $5 in interest. That’s cash out flow of $25.
So what the investor is left with is a $75 profit! Well done!
How does my Broker make money from shorting?
You might not think it, but the broker also wins the from the deal because if they did not enter into the contract, which cost them nothing, they would be sitting on losses of $80 because the shares are now priced at 20 cents each.
But thanks to the 5% in interest some of the risk was avoided.
For brokers and large pension funds, conservatively lending shares to be shorted by investors can be a simple way to make a few extra percent in interest. Especially if they will be required to hold them through a market crash.
For investors, short selling can be very risky because losses are unlimited. When a share that you have shorted starts to rise unexpectedly it’s called a short squeeze because many investors often have to rush back into the share market to avoid losses.
Nonetheless, shorting can be profitable if you pick an investment’s timing and direction correctly.
Is shorting bad?
Legitimate short sellers play a vital role in ensuring investment markets and CEOs are doing their job correctly.
How to borrow stock to short sell
Short selling is sometimes reserved only for large or sophisticated investors. The easiest way to find stock to borrow in Australia is to visit the website of popular brokerage firms.
Some of the big firms offer a platform for smaller investors to short sell. However, always beware of the risks and fees.
Short selling is risky
Short selling can be a very risky strategy. So, if you're in Australia, only engage with a licensed broker or investment firm (tip: check their AFSL number on the ASIC website) and always read the T&C's.