Investing usually involves buying something you believe will go up in value. However, you can also take advantage of a fall in the price of a share, or any other asset, by “shorting” it.
This means selling a share that you borrow but don’t own, with the intention of buying later on at a lower price and returning it to the owner. If you get it right, you make a profit from the difference in the price at which you sell and the price at which you buy.
Obviously, when you sell a share, you have to hand it over to the new buyer almost immediately. So when you short a share, you’ll need to borrow it from another shareholder until the point at which you decide to close the short by buying the share. You’ll normally be charged interest on this loan, based on the value of the shares, at the price charged when they loaned them to you. How much you need to pay depends on how difficult it is to borrow the shares. This means that the longer you keep a short going, the more it costs you – so shorts are typically relatively short-term trades rather than long-term positions.
Shorting is risky. If you buy shares then your gains are theoretically unlimited, and your losses are fixed at the value of your initial investment. With shorting it’s the other way around since you could lose far more than the initial value of your position if it increases enough in value. If you short a share at £1 and it rises to £50, you’ve lost £49. However, the most you could make is £1 (assuming the value of the share goes to zero).
Consequently, short-sellers will normally use a stop-loss that will automatically close their position once a share reaches a certain level. The downside of a stop-loss is that you could be forced to exit the position (or be “stopped out”) by a temporary surge in the price. In some cases, a large number of short-sellers can be forced to close their positions, causing a further increase in the price as they are forced to buy back the shares. This is called a “short squeeze”, and can end up being very expensive for the short-sellers who don’t get out in time.
The potential for a short squeeze means that some investors look for shares that are heavily shorted and buy them. They argue that this increases the chances of a short squeeze. Contrarian investors also argue that high levels of shorting are a sign of excessive pessimism. However, some research has come to the opposite conclusion. A 2007 study by Eric Kelley and a 2008 study from Ferhat Akbas, both from Texas A&M, found that shares that are heavily shorted tend subsequently to lag the market in the near term, suggesting that it’s best to avoid betting on them rebounding.