Shorting - an investment strategy for the bold

Most investment strategies are about buying cheap and selling dear. This is the name of the game in investing. But what if there's an opportunity to profit from the opposite - a fall in asset prices? That's what shorting is. In this article, we'll take a closer look at what shorting is, how it's used and what risks it entails.

What is shorting?

Shorting, also known as short positioning, is the investment strategy, which differs from the traditional "buy cheap, sell high" approach. Instead, the investor speculates on the fall in the price of an asset, hoping to make a profit by selling it and then buying it back at a lower price.

In a traditional "long position", the investor buys an asset (e.g. Shares) in the hope that its price will rise in the future. In contrast, with shorting, an investor borrows assets (e.g. shares) from a broker and immediately sells them at the market price. The investor then hopes that the price of the asset will fall, at which point he or she can buy it back at a lower price and return it to the broker. If all goes according to plan, the investor earns the difference between the transactions as income.

For example, an investor believes that the share price of company X is overvalued and is about to fall. He borrows 100 shares of X from a broker and immediately sells them at a market price of €10 per share, earning €1000. He then expects the share price to fall to, say, €5 per share. At that point, he buys back 100 shares X from the market at €5 per share and returns them to the broker. As a result of this transaction, the investor has earned €5 per share, giving a total profit of €500 (€1000 of the sale proceeds minus €500 of the purchase price).

Important terms

Short position: An investment made in anticipation of a fall in asset prices.
Short seller: An investor who takes a short position.
Covering: Closing a short position by buying back assets.

How is short selling used?

Shorting can be used for several different purposes:

Speculation: This is the most common reason for shorting. An investor believes that the price of an asset will fall in the future and wants to profit from this fall. For example, if an investor believes that the share price of company X is overvalued and is going to fall, he or she may short the shares, hoping to make a profit if the price falls.

Hedging (protection): An investor may short an asset to protect against a fall in the value of existing assets. For example, if an investor has a large number of stocks in his portfolio, he may short stock index futures to reduce the risk to his portfolio if the stock market falls.

Valuation (fundamentals): Some investors believe that certain assets are overvalued and will short them in order to make a profit if the asset price falls to its fair value. For example, if an investor believes that company X's financial statements are dishonest and the company is not actually as successful as it claims, he or she may short the shares, hoping to make a profit if the share price falls after the fraud is exposed.

In addition to the above, it is also important to familiarise yourself with the following concepts:

Short interest: This is the number of shares that have been borrowed and sold short. A high short interest indicates that many investors believe that asset prices will fall.

Short squeeze: This is a situation where short sellers are forced to buy back assets quickly as the asset price rises sharply. This can happen when positive news about an asset leads to a surge in investor demand and price. For example, if company X announces unexpectedly large profits, share prices can rise sharply, forcing short sellers to buy back shares quickly, leading to an even higher price increase.

Example:

Let's say an investor believes that company X has defrauded its investors and presented inaccurate financial statements. He believes that the company's share price will fall sharply if the fraud is exposed. So he lends 1000 shares of X to a broker and immediately sells them at a market price of €10 per share, earning €10 000. The investor then expects the share price to fall when the fraud is discovered. When the share price falls to €5 per share, he buys back 1000 shares of X on the market at €5 per share and returns them to the broker. As a result of this transaction, the investor has earned €5 per share, giving a total profit of €5,000 (€10,000 of the sale proceeds minus €5,000 of the purchase price).
It is important to note that shorting is a sophisticated investment strategy suitable for experienced investors. It is a risky strategy, as the investor faces potentially unlimited losses if the asset price rises. It is important to carefully research the asset and consider all risks before shorting.

Short selling risks and limitations

While shorting can be a profitable investment strategy, it also comes with significant risks and limitations that should be considered before investing:

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Potentially unlimited losses

Unlike traditional investing, where the maximum loss is limited to the amount invested, short selling has potentially unlimited losses. This is due to the fact that the price of shares can, in theory, rise indefinitely. If a short seller makes a wrong prediction and the share price rises sharply, he could lose a lot of money.

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Margin requirements

Shorting is often done on margin accounts that require additional capital from the investor. This means that the investor has to deposit a certain percentage of the value of the asset in their account to cover their investment. If the price of the asset rises, the investor may be required to contribute additional capital, which can lead to margin calls, where the investor is forced to liquidate his position, even if he is loss-making.

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Borrowing costs

Investors have to pay interest on the assets they borrow. This extra cost reduces the potential profitability of short selling.

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Short squeeze risk

A short squeeze occurs when a large number of short sellers are forced to buy back assets quickly because of a sharp rise in the asset price. This can happen as a result of positive news or unexpected events that lead to a surge in investor demand and price. During a short squeeze, short sellers can lose significant money as they are forced to buy assets at higher prices.

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Regulatory restrictions

Some regulatory authorities may restrict short selling under certain conditions. For example, they may prohibit short selling in volatile markets or in crisis situations.

In addition, it is important to note that shorting is a sophisticated investment strategy suitable for experienced investors. It requires in-depth knowledge and experience of financial markets and the ability to manage risk. It is important to carefully research the asset and consider all the risks before shorting.

Examples from real life

Michael Burry and the collapse of the US housing market (2008)

One of the most famous examples of shorting relates to the US housing market in 2008. Investor Michael Burry predicted that the rise in house prices is unreliable and is a big bubble in the property market. He used sophisticated financial instruments to short sub-prime mortgage-backed bonds. Subprime mortgages were loans made to at-risk customers with low incomes or poor credit ratings.

Burry bet that many sub-prime borrowers would not be able to repay their loans, leading to widespread mortgage delinquencies and a collapse of the housing market. His prediction was right - when the housing market collapsed in 2008, Burry and his investment fund made huge profits. The story has been told in books and in the film "The Big Short".

Hindenburg Research and electric car manufacturer Nikola (2020)

In 2020, the investment firm published Hindenburg Research report on electric car manufacturer Nikola, accusing the company of fraud and making false claims about its technology. Hindenburg Research also shorted Nikola's shares, hoping for a fall in their price.

Nikola's share price fell sharply after the publication of a report by Hindenburg Research as investors lost confidence in the company's management and the robustness of its technology. Although Nikola later disputed the allegations in the report, Hindenburg Research apparently made a significant profit on the shorting.

These are just a few examples of how short selling has been used in financial markets. It is important to remember that these are also success stories - shorting can also end in big losses if the investor guesses wrong and the asset price rises.

Summary

Shorting is a sophisticated investment strategy for the bold. It allows you to make profits even if asset prices fall, but it also carries significant risks. An investor can lose unlimited amounts if asset prices rise. There are also margin requirements, borrowing costs, the risk of a "short squeeze" and regulatory restrictions.

It is crucial to thoroughly research the asset and consider all the risks before shorting. Shorting is more suited to experienced investors with a good knowledge of financial markets and the ability to manage risk. If you are just starting out in investing, it makes more sense to start with traditional investment techniques.