31 May 2021

All you need to know about Short Selling

SALONI SURI, Investor Relations Executive.


Overview

Short selling is a simple concept—an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender. In the period between selling borrowed stock and buying it back the investor is said to be ‘Short’ of stock, hence the term short selling.  The difference between the price at which the borrowed security was sold and the price at which it was purchased represents the short seller’s profit or loss. ‘Shorting’ essentially boils down to a bet on expectations of future prices, with the short seller hoping to buy shares back at a lower price than they sold them.

Why it occurs?

Short selling is likely to manifest in periods of high uncertainty or volatility when traders seek to capitalise on predictions and forecasts for a future price decline.

A good example of opportunistic short selling in response to macro-economic impacts is the speculation around how the Coronavirus pandemic impacts tourism stocks like Webjet and Flight Centre. There has been an increase in shorting of these stocks on expectations the travel industry will continue to struggle because of COVID-19 constraints on international travel leading to share price declines within the sector and the possibility of corporate failure. Institutions or specialist funds may also take a more aggressive approach by undertaking a  short selling campaign or ‘short attack’ focused on a particular stock whose share price they view as overvalued and predict will fall sharply. In some cases the fact that large short positions are being built can be enough to spook the market and cause a share price decline.

Short selling requires access to stock. The custodian or nominee companies that hold stock on behalf of many long-term fund managers or asset owners often have agreements with them, giving them the right to loan out their stock within a predefined period, usually in return for lower admin fees.

Fund managers also run different portfolio strategies that can include short selling, a good example being the Long Short Fund. Long short funds are designed to maximize the upside of markets, while limiting the downside risk. For example, they may hold undervalued stocks that the fund managers believe will rise in price, while simultaneously shorting overvalued stocks in an attempt to reduce losses.

Hedge funds are among the most active short-sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks.

Consequences for trading:

  • Margin call requirement: In some cases short sellers may use borrowed money for investment purposes and be subject to the minimum maintenance margin requirement of 25% of the total value of the securities. When the account slips below the 25% standard, margin calls occur and force investors to either sell/liquidate the position or put in more cash.
  • Timing issues (trading vs settled positions) involved in the process of short selling. This may also impact attempts to reconcile where stocks are held at a given time
  • Legal restrictions on short selling activities for certain stocks or for stocks in certain countries subject to regulatory restrictions.
  • Transition of funds between owners may increase the volume of funds held by collateral and lending accounts of market makers – brokers like Goldman Sachs or Merrill Lynch.
  • Volatility and market manipulation can artificially affect trade flows and share ownership.

A company’s periodic analysis of their beneficial ownership will provide insights into the stock borrowing and lending activity on the register. It won’t of itself tell you who is engaging in short selling. As one of the few providers in the market to do this work, we have developed techniques over time that enable us to identify who is behind short selling activity. While it is intelligence that we are able to provide clients where we have deep knowledge of the register we also undertake this analysis on request.

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