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What is short selling?

Adit Kashyap | May 20th, 2023

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Source: NPR

Introduction

Short selling, also known as "shorting," is a type of investment strategy where an investor bets that a particular stock or asset will decrease in value over a certain period. Short selling has been a popular investment strategy for many years, and it is used by both individual investors and professional traders alike. However, short selling can be a risky strategy, as it involves borrowing shares of a company from a broker and selling them, hoping to buy them back at a lower price later and return them to the broker. In this article, we will discuss in detail the exact procedures that are followed in most stock exchanges while conducting short selling.

Understanding what short selling is

Short selling is an investment strategy where an investor borrows shares of a company from a broker and sells them in the market, hoping that the price of the shares will decrease in the future. The investor then buys the shares back at a lower price and returns them to the broker, pocketing the difference as profit.

Short selling is essentially the opposite of buying a stock, as the investor is betting that the price will go down instead of up.

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Short selling is often used as a hedge against long positions, where an investor owns shares of a company and is bullish on its future prospects. By shorting the same company, the investor can protect themselves against any potential losses in the long position if the stock price were to decline.

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Short selling is not limited to stocks and can also be applied to other assets such as commodities and currencies. However, the procedures for short selling differ slightly depending on the asset being shorted.

Procedures for short selling in stock exchanges:

Short selling is a regulated activity, and stock exchanges have specific procedures in place to facilitate it. These procedures are designed to ensure that the short-selling process is transparent, fair, and does not cause any undue harm to the market or individual investors.

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  1. Locate the Shares to Short: Before an investor can short a stock, they must first locate the shares to borrow. This is done through a process called "stock loan," where the investor borrows the shares from a broker who holds them in inventory or borrows them from another investor.
     

  2. Check for Availability and Fee: Once the shares have been located, the investor must check the availability and the fee for borrowing the shares. This fee is known as the "short interest rate," and it varies depending on the demand for the shares and the perceived risk associated with shorting the stock.
     

  3. Place the Short Sell Order: Once the investor has located the shares and determined the short interest rate, they can place a short sell order with their broker. This order is similar to a regular buy or sell order but is executed in reverse, where the investor is selling the shares first and buying them back later.
     

  4. Margin Requirement: To place a short sell order, the investor must also meet a margin requirement set by the exchange. This margin requirement is typically 50% of the value of the shares being shorted and is designed to protect the broker and the market against any potential losses that may arise from the short selling activity.
     

  5. Marking the Order: Once the short sell order has been placed, it is marked as a short sale in the market. This allows other investors and traders to see that the investor is betting against the stock and may influence their own trading decisions.
     

  6. Settlement Process: The settlement process for short selling is different from that of regular buying and selling of stocks. When an investor sells a stock short, they are essentially borrowing it from the broker or another investor and selling it in the market. The investor must buy the shares back at a later date to return them to the lender.
     

  7. Buy to Cover: The process of buying back the shares to return them to the lender is known as "buy to cover." This is done by placing a buy order for the same number of shares that were initially sold short. The goal is to buy the shares back at a lower price than the short sell price, resulting in a profit.
     

  8. Short Sale Price Test Circuit Breaker: To prevent excessive volatility in the market, some stock exchanges have implemented a "short sale price test circuit breaker." This circuit breaker is triggered when the price of a stock drops by a certain percentage in a single trading day. When triggered, the circuit breaker prohibits short selling for the remainder of the trading day and the following day.
     

  9. Short Squeeze: One risk associated with short selling is the possibility of a "short squeeze." A short squeeze occurs when a large number of investors are shorting a particular stock, and the price unexpectedly rises. This can force short sellers to buy back the shares at a higher price, leading to a rapid increase in the stock price and potential losses for the short sellers.

Risks of short selling

Short selling is a popular investment strategy that can be used to profit from falling stock prices. However, short selling can also be a risky strategy, as it involves borrowing shares of a company and selling them in the market, hoping to buy them back at a lower price later and return them to the lender. Below are some of the risks associated with short selling, along with historical examples to illustrate these risks:
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  1. Unlimited Loss Potential: One of the most significant risks associated with short selling is the potential for unlimited losses. Unlike buying a stock, where the maximum loss is limited to the initial investment, short selling has no cap on potential losses. This is because the price of a stock can theoretically continue to rise indefinitely, resulting in a loss for the short seller.

     

    - Historical Example: In 2008, shares of Volkswagen (VOW3.DE) surged after Porsche disclosed a 74.1% stake in the company, catching many short sellers off guard. The short squeeze that followed resulted in billions of dollars in losses for hedge funds and other investors who had bet against the stock.
     

  2. Short Squeeze: Another risk associated with short selling is the possibility of a short squeeze. A short squeeze occurs when a large number of investors are shorting a particular stock, and the price unexpectedly rises. This can force short sellers to buy back the shares at a higher price, leading to a rapid increase in the stock price and potential losses for the short sellers.

     

    - Historical Example: In 2021, shares of GameStop (GME) experienced a short squeeze after a group of retail investors on the Reddit forum WallStreetBets coordinated to buy shares of the company, driving up the price and forcing hedge funds that had bet against the stock to buy back shares at a higher price.
     

  3. Regulatory Risks: Short selling is a regulated activity, and there is always the risk that regulators may change the rules or impose new restrictions on short selling. This can limit the ability of short sellers to profit from falling stock prices and can result in losses for investors who are caught off guard.

     

    - Historical Example: In 2008, several European countries, including France, Germany, and the United Kingdom, temporarily banned short selling in an attempt to stabilize the markets during the financial crisis.
     

  4. Margin Calls: When an investor shorts a stock, they are required to put up margin collateral with their broker to cover any potential losses. If the value of the stock rises too much, the broker may issue a margin call, requiring the investor to put up additional collateral or risk having their position closed out.

     

    - Historical Example: In 1992, George Soros famously shorted the British pound, betting that it would decline in value. However, the Bank of England intervened to prop up the pound, causing its value to rise and resulting in significant losses for Soros and his hedge fund.
     

  5. Market Volatility: Short selling can be particularly risky in volatile markets, as sudden price swings can result in significant losses for short sellers. This is because short sellers must buy back the shares they have sold in the market, which can be difficult and expensive during times of high volatility.

     

    - Historical Example: In 2010, the flash crash resulted in a sudden and significant decline in the stock market, causing losses for many investors, including short sellers.

Ethics of short selling

Short selling, as an investment strategy, has long been a topic of debate when it comes to its ethical implications. While some view it as a legitimate and essential component of a well-functioning market, others argue that it can contribute to market manipulation and financial instability. In this essay, we will delve into the ethics of short selling, exploring both the arguments in favour of and against this practice. By examining various perspectives, we aim to provide a comprehensive analysis of the ethical considerations surrounding short selling.

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  1. Market Efficiency and Information Dissemination: One of the primary arguments in favour of short selling is that it enhances market efficiency by allowing investors to express negative views on specific stocks. Short sellers contribute to the price discovery process by highlighting potential overvaluation and uncovering information that may not be widely known. This aspect of short selling encourages transparency and promotes a more efficient allocation of resources in the market.

    - Historical Example: The collapse of Enron in 2001 revealed fraudulent practices and accounting manipulations that had been concealed from the public. Short sellers, such as Jim Chanos, had expressed scepticism about Enron's financials prior to its downfall, playing a critical role in uncovering the truth and warning investors.
     

  2. Mitigating Market Bubbles and Excessive Speculation: Short selling can act as a counterbalance to market bubbles and excessive speculation. By allowing investors to bet against overvalued assets, short selling helps prevent irrational exuberance and excessive optimism from distorting market prices. This function can contribute to more stable and sustainable market conditions.

    - Historical Example: During the 2008 financial crisis, a number of financial institutions engaged in risky practices and inflated asset prices. Short sellers, such as Michael Burry, who predicted the housing market collapse, profited from their scepticism, while also exposing the underlying risks and contributing to a more realistic assessment of the market.
     

  3. Ethical Concerns: Market Manipulation and Exploitation: Opponents of short selling raise concerns about its potential for market manipulation and exploitation. Critics argue that short sellers can spread negative rumours or engage in aggressive tactics to artificially drive down stock prices, causing harm to companies, their employees, and other investors. Additionally, short selling can be seen as profiting from the misfortune of others, as the gain of a short seller comes at the expense of someone else's loss.

    - Historical Example: In 2015, the pharmaceutical company Valeant Pharmaceuticals faced intense short selling pressure after questions were raised about its business practices and accounting. The aggressive tactics employed by some short sellers, coupled with media coverage, contributed to a significant decline in the company's stock price, generating controversy and highlighting the potential ethical concerns associated with short selling.
     

  4. Systemic Risks and Financial Stability: Another ethical consideration revolves around the potential systemic risks and impact on financial stability that short selling can pose. Critics argue that short selling, especially during periods of market distress, can exacerbate price declines and contribute to a downward spiral, potentially destabilizing the entire financial system. Furthermore, the use of leverage in short selling can amplify risks and lead to cascading effects.

    - Historical Example: During the 1997 Asian financial crisis, short selling played a role in exacerbating market declines and contributed to increased volatility. The practice came under scrutiny, leading some countries to impose temporary bans on short selling to stabilize their markets.
     

  5. Impact on Companies and Stakeholders: Short selling can have significant consequences for companies and their stakeholders. Critics argue that aggressive short selling tactics, such as spreading negative rumours or engaging in manipulative strategies, can harm companies' reputations, disrupt their operations, and potentially lead to job losses. This raises ethical concerns about the fairness and potential collateral damage caused by short selling.

    - Historical Example: In 2019, a prominent short seller released a report accusing a multinational company of fraudulent accounting practices. The report caused a significant decline in the company's stock price and triggered investigations, leading to job losses and reputational damage. While the allegations were eventually proven to be true, the impact on employees and other stakeholders underscores the ethical considerations of short selling.
     

  6. Regulatory Safeguards and Fairness: The presence of robust regulatory frameworks is crucial in ensuring fairness and preventing abusive practices in short selling. Regulations often include disclosure requirements for short positions, restrictions on certain trading activities, and measures to address market manipulation. Ethical debates surrounding short selling often centre on striking the right balance between allowing market participants to express negative views and maintaining a level playing field for all investors.
     

  7. Market Transparency and Information Asymmetry: Ethical concerns may arise from information asymmetry between short sellers and the broader market. Short sellers often conduct extensive research and analysis, which can uncover valuable information about a company's weaknesses or potential risks. However, there is a risk that this information is not equally available to all market participants, leading to an imbalance in the quality and accessibility of information. This raises questions about fairness and the potential for insiders or well-connected individuals to gain an unfair advantage in short selling activities.
     

  8. Short Selling and Corporate Governance: Short selling can also serve as a mechanism to improve corporate governance practices. By scrutinizing companies and highlighting governance issues, short sellers can encourage companies to address weaknesses and adopt more responsible practices. This can contribute to long-term sustainability and accountability within the corporate sector.

    - Historical Example: Short sellers played a role in exposing governance failures and accounting irregularities in companies like WorldCom and Tyco International during the early 2000s. The revelations led to reforms in corporate governance practices and increased investor scrutiny.
     

  9. Psychological and Emotional Impact: Short selling can have psychological and emotional consequences for investors, particularly when they take positions against companies that may have a positive societal impact or are held in high regard by the public. Ethical considerations extend beyond financial outcomes to the potential emotional toll on individuals and the broader perception of short selling in society.
     

  10. Social and Environmental Impact: Short selling raises ethical concerns regarding its potential impact on socially responsible companies and sectors. Critics argue that short sellers may target companies that are actively working towards positive social or environmental outcomes, potentially hindering their progress. This raises questions about the alignment of short selling practices with broader societal goals and responsible investing principles.

    - Historical Example: Tesla, a prominent electric vehicle manufacturer, has been a target of short sellers who questioned the company's valuation and its ability to deliver on its ambitious sustainability goals. This highlights the tension between short selling strategies and companies aiming to drive positive environmental change.
     

  11. Ethical Investing and Short Selling: The rise of ethical investing, which considers environmental, social, and governance (ESG) factors, has led to discussions about the compatibility of short selling with sustainable and responsible investment practices. Investors who prioritize ethical considerations may question the ethics of profiting from the decline of companies or industries that align with their values.

    - Historical Example: In recent years, ethical and sustainable investment funds have emerged, explicitly excluding companies involved in controversial industries such as tobacco, firearms, or fossil fuels. The inclusion of short selling within these funds raises debates about the ethical boundaries of responsible investing.
     

  12. Legal and Ethical Gray Areas: Short selling operates within legal frameworks, but there may be ethical grey areas that are not explicitly addressed by regulations. For example, the practice of "naked" short selling, where shares are sold without borrowing them, can raise ethical concerns due to the potential for market manipulation or excessive risk-taking.

    - Historical Example: During the global financial crisis of 2008, naked short selling came under scrutiny as regulators implemented measures to address its potential negative impact on market stability. The ethical implications of such practices continue to be debated, emphasizing the need for ongoing scrutiny and regulation.
     

  13. Individual vs. Systemic Ethics: The ethics of short selling can be viewed through both an individual and systemic lens. From an individual perspective, short selling may be considered ethically acceptable as long as it adheres to legal requirements and does not involve fraudulent or manipulative practices. However, when considering the broader systemic impact, questions arise about the potential for short selling to contribute to market volatility, financial instability, and negative social consequences.

    - Historical Example: The 2010 Flash Crash, where the U.S. stock market experienced a rapid and severe decline followed by a quick recovery, raised concerns about the role of high-frequency trading and short selling in exacerbating market volatility. The event highlighted the need for systemic ethical considerations in market practices.

Conclusion

Short selling is a popular investment strategy used by both individual investors and professional traders. However, short selling can be a risky strategy, as it involves borrowing shares of a company and selling them in the market, hoping to buy them back at a lower price later and return them to the lender. Stock exchanges have specific procedures in place to ensure that the short selling process is transparent, fair, and does not cause any undue harm to the market or individual investors. Understanding these procedures is essential for any investor looking to engage in short selling and can help mitigate potential risks associated with this strategy.

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The ethics of short selling are multifaceted, involving considerations related to market efficiency, information dissemination, fairness, market manipulation, systemic risks, corporate governance, psychological effects, regulatory safeguards, social and environmental implications, and the impact on companies and their various stakeholders. Balancing the potential benefits of short selling, such as price discovery and preventing market distortions, with the need to ensure integrity, fairness, and responsible conduct is essential. Effective regulation, transparency, and ethical practices by market participants are key in navigating the complexities of short selling and fostering a sustainable and ethically sound investment environment.

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