Should you short stocks?

Short-selling often grabs the financial headlines for example, on Friday China's regulators introduced new rules to make it easier, resulting in a drop in Shanghai and Shenzhen stocks. For many investors, understanding how shorting works and why it matters can seem confusing. Yet while it is definitely risky and only suitable for experienced traders, the principles are relatively simple.

Short-selling means selling an asset such as a share that you borrow but don't own, in the hope that the price will decline. If it does, you'll be able to buy it back at a lower price, and make a profit from the difference between the price at which you sold and the price at which you bought.

For example, let's assume that an investor decided to short Tesco in August 2014, believing that the firm's results were set to get even worse. So they sold shares at around 230p. Their timing was excellent: Tesco shares plummeted in September after an accounting scandal. In October, our investor then bought Tesco shares at 180p, closing their short position and making a profit of 50p per share.

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Paying to borrow

That's because when they initially sold the shares, the investor who bought them would expect to take delivery in the usual way. So the short-seller would have to borrow shares from somewhere to be able to hand them over.

They would have to pay the lender of the shares (typically a large institutional investor trying to earn a bit of extra income) a daily fee for this, until they close the short by buying back the Tesco shares and returning them to the lender. The cost of borrowing depends on the stock. When it's difficult to get hold of shares because the company is small or it's already a very popular short, the fee will be higher.

Of course, shorts don't always go to plan and when they don't, they can be very costly. Let's assume our investor decided to short semiconductor design firm Arm Holdings in early 2012 and sold shares at 600p. At first, the trade would have gone well Arm dropped to around 500p in the middle of the year.

But our short-seller decided that there were bigger profits to come and held on. Arm shares rapidly began to rise again, and reached more than 1,100p in 2013. At this point, the short-seller would have been sitting on a loss of more than 600p per share.

In reality, it would be unusual for a short-seller to keep a big losing position open as long as this: as the shares continued to rise, their broker would be demanding that they put up more collateral (money or assets to cover their paper losses on the trade).

For most people, this 'margin call'would prompt them to close the short position. Nonetheless, it demonstrates the potential risks from shorting. Hence risk management is a crucial part of shorting.

Good short-sellers generally run several diversified shorts and only allow each one to be a small part of their portfolio. They also typically focus on stocks that they believe are fraudulent, or at risk from some other event that the market has not recognised, rather than simply overvalued. Research suggests that fraud shorts have a much better record than valuation shorts see here for details.

Short-selling is often controversial.Critics accuse short-sellers of spreading false rumours and damaging good companies. But while this may sometimes happen, short-sellers also help to challenge consensus and expose problems. This means that they play a valuable role in making markets work better.