One of the most debatable topics when it comes to investing strategies is short selling. When in principle there is nothing wrong with short selling, policymakers and financial regulators remain sceptic and suspicious with regards this market practice given abusive market practices and the potential risks involved.
Often perceived as highly risky strategies, short sell strategies have been abruptly banned in certain financial markets as “bear raids” were attributed having substantially manipulated share prices by spreading false rumours and speculating with short selling strategies. However, in order to conclude whether this common market practice is unsafe for investors and harmful to the financial system, it is essential to comprehend its mechanic and analyse both sides of the coin.
How does a short sell strategy work?
Traditionally, in a long strategy, a stock investor requires to hold (or be long on) a particular share to be able to sell it in the market. His ultimate objective is to make profits by purchasing the share at a low value and selling it in the market at a higher price. In a short selling strategy, by contrast, a stock trader anticipates the falling of prices of certain share and since he is not in possession (or short) of that particular stock, the investor borrows the share from a broker at a lending fee. The brokerage firm might get that particular share from current clients holding the stock (since same stocks are fungible, the broker might transfer stocks between its different clients) and lend them to the seller.
Once the investor has the share in his portfolio, he sells it to a counterparty at market price (the transaction is usually executed as soon as the borrower receives the shares so he benefits from selling at high price). However, this does not conclude the transaction as the borrower still needs to give back the shares to the lender. Subsequently, the seller waits until market prices fall in order to purchase the stock at low value and return it back to the broker. It is important to note that the borrower must compensate the stock’s owner for any dividend or rights paid during the time period he held the stocks.
In essence, whilst the traditional stock investment approach comprises achieving market gains by purchasing a stock and waiting to sell it until it’s value appreciates (buy and hold), the reasoning behind short selling lies in the expectation of declining share prices and the opportunity to take gains from borrowing the share, selling it while the price is high and buying it back once the market price reached the low levels. Short selling contracts are not limited to shares and can be used a wide range of financial assets, though.
What are the risks involved with short selling?
Given the scenario that market performance reacts contrarily to the bearish expectations, the maximum possible loss in a traditional stock investment will occur when share prices reach zero; thus, limiting the maximum loss to the total position amount as share prices cannot be negative. Short Sell strategies, by contrast, have a virtually unlimited possible losses as the seller has the obligation to return the stock to the lender but market fluctuations might increase share prices to that extent that the cost of purchasing the stocks raises indefinitely.
Additional concerns involve market participants carrying out abusive practices during highly volatile sessions and periods of crisis, as short selling strategies might dramatically plunge security prices by spreading false rumours and manipulating the market. Other questionable market practices such as Naked Short Selling (the uncovered version of regular short selling strategies), Short Squeezing and Short Psychology techniques have been proven harmful to the financial system and the Security Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA) have taken solid measures during recent years to protect companies and the system from the negative impact of these practices.
Are short sell strategies dangerous games?
It is true that short selling involves the risk of taking unlimited losses if the strategy is planned and executed without proper scrutiny but, to be fair, short sells also provide considerable benefits to speculators, hedgers and the financial system in general:
First, this investment practice allows injecting additional liquidity to the market and provides alternative investment strategies. Second, given their high exposure to latent risks and potential infinite loses, short sell transactions are mostly used as hedging strategies rather than speculative instruments. By considering using short sell strategies, long position investors (who aim to sell a security at high price) might protect their position against black swan events and sudden drop of prices.
On the other hand, with regards of the financial system in general, short selling strategies make markets much more efficient by timely identifying trend reversals and occasionally preventing markets to overreact to excessive optimism/pessimism that might lead to speculative bubbles. Furthermore, despite that short sell practitioners have been subject to constant criticism, they play a substantial role for compliance officers; according to Warren Buffet, short sell practitioners become very useful when it comes to uncovering fraudulent activities and earning manipulation cases, as they seem to have insider information that encourages them to timely execute short sell transactions before the market reacts to the new information.
While international regulators are slowly reaching measures to avoid market abuse and systemic disruptions derived from short selling strategies, investors must be well aware that short selling is a highly risky practice as the strategy lies in prices expectations; however, this risk exposure is not exclusive to short selling and is very well known in the financial industry. Short sell strategies could be dangerous in fact; however, like any other risk in life, dangerous strategies must be planned and executed with scrutiny and common sense.
Adrian Cuevas
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