“Short selling” as explained to my neighbor Phil
“Short selling”, “shorting” or taking a “short position” in a share is to bet that its price will fall. Shorting is therefore the opposite of buying and holding a share (known in the trade as going “long”).
What’s the difference between ordinary selling and short selling? In normal life you buy things you want but don’t already have, and you sell things you already have but do not want. Short selling is to sell something you don't already have.
This is where the concepts of “long” and “short” and flat are useful. They talk about your economic “exposure”.
If you do not own a share at all, you are “flat”: indifferent to whether its price changes. You have “no exposure”.
If you buy the share, you go “long”: it it goes up, you gain. If it goes down, you lose. This is “positive exposure”
If you sell it again, you become flat again. Back to no exposure.
How would you get negative exposure? In order to go “short” you would have to somehow sell a share you don’t already own — and therefore go from flat to negative exposure. Logistical problem, though: how do you get hold of a share you don't already own?
You borrow it. But what you borrow you must, at some point, return. When that time comes, you must buy the share back in the market, so you can give it back to the lender. This is how you get that negative exposure: the cheaper the share is to buy back, the more gain you make.
The process of “putting on a short” is therefore two separate transactions: a “stock loan” with a stock lender, for which you pay the lender a running fee, and a share sale to a different buyer in the market. To “close out your short”, you must do the reverse: buy a share in the market, and redeliver it to your lender to terminate the stock loan.
Short selling is risky. Your potential profit is limited, because shares cannot go below zero value. Your potential loss is unlimited: shares can go up in value without theoretical limit. This is the opposite (of course) to long investing, where your upside is unlimited, but you can only lose your current investment.
Financial concepts my neighbour Phil was asking about when I borrowed his mower.
From our machine overlords
Here is what our cheeky little GPT3 chatbot
had to say when asked to explain:
A short sale
is a securities transaction in which an investor sells a security
that it does not own, intending to buying it back later at a lower price.
In a short sale, the investor “borrows” the security from a broker and then sells it on the market. If the price of the security falls as expected, the investor can buy it back at the lower price, return it to the lender, and pocket the difference as profit. But if the investor is a poor defenceless hedge fund titan and some greasy day-traders on Reddit gang up on him, deliberately buying the the security just to piss on his chips and make it go higher, the poor little master of the universe will get his arse handeed to him and will spend the next three years writing investor letters explaining how he managed to lose seven billion dollars and torpedo his whole fund with a sure-fire bet against a lagging performer in an anyway dying industry. This is just not fair and there is absolutely no call for any kind of schadenfreude here.
Short selling can be a risky investment strategy, as the potential losses are theoretically unlimited, especially if you trade at the bottom of the range, because there is no upper limit to how high the price of a security can rise.
As a result, short selling is generally only suitable for experienced investors who understand the risks and have the financial resources to absorb potential losses. This turned out not to include the portfolio managers at Melvin Capital Management LP.
Disclaimer: he’s a neural network, he drinks a lot, and he spends too much time on the internet, so if you listen to anything he has to say you only have yourself to blame.
The practice of selling a security you don’t own in the first place, meaning you have negatively correlated exposure to the price of the security. To do this you will need to borrow the stock under a stock loan, and the agreement you will want for that, if you’re in the English speaking world outside America, will be the 2010 GMSLA. Note though that the stock loan isn’t the thing that makes you short, but your sale of the security you’ve just borrowed. Seeing as you have to return it, and you don’t have it, you will have to buy it. Obviously this works best for you if the stock declines in price in the mean time. That’s the point of your trade, see? During that period, you are paying the financing cost of that stock under your stock-loan.
Short selling is risky for you — your losses can be conceptually infinite — and for the issuers of the securities you short sell, especially if they happen to be financial institutions. Therefore this activity is regulated in many jurisdictions, including the EU in their wonderfully entexted EU Short Selling Regulations.
It is risky for the prime broker too
Spare a thought for your much-maligned prime broker. On an ordinary margin loan the prime brokers maximum loss is capped at the value of the the loan: you can only lose what you have given away. This is not so with a stock loan: here the borrower theoretically unlimited exposure to the upside means the prime broker has unlimited second-loss exposure too. That is to say, once it's client is wiped out, the prime broker wears the remainder of the loss.
The unexpected emergence of the GameStop horcrux in early 2021 has undoubtedly provoked pause thought amongst prime brokerage risk managers across the city, especially as regards their margin lock-up arrangements with funds who who like to hang out in crowded shorts.
Other ways of going short
You can achieve a similar effect in a number of ways: