When most of us put money in the stock market, we go long – buying shares that we believe will go up. Short-sellers do the opposite – they aim to profit from a share price falling.
A short-seller borrows the shares from someone who already owns them and sells them in the open market. If the price falls, the short-seller buys the shares back at the lower price, returns them to the lender and pockets the profit.
So, for example, say you want to “short” shares in troubled high-street chain Beta Retail, which currently trades at £1 a share. You borrow 10,000 shares from an index fund (which owns them because it simply tracks the underlying index) in return for a small fee.
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You then sell them. So you now have £10,000 (less your borrowing costs), but you owe the index fund 10,000 Beta shares. However, Beta issues a profit warning later that month, and the share price falls to 80p as a result. You buy 10,000 shares back for £8,000. You return the shares to the index fund and pocket a £2,000 profit.
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Of course, if Beta had issued a surprisingly positive set of results and the share price had shot up to £1.20, say, then you’d still have to buy back the shares and return them to the index fund, but in doing so, you’d have made a loss of £2,000.
This is one of the many reasons why shorting is extremely risky and not to be undertaken lightly. If you are long, the worst that can happen is that the share price goes to zero and you lose 100% of your money. With short-selling, your losses are technically unlimited, as there is no ceiling on how high a share price can rise. And you must get the timing right. Long investors can buy and hold, but shorts can only afford to keep positions open for a limited time.
Short-sellers are often unpopular and blamed for driving down the share price of companies they target. However, they can play a key role in uncovering fraud or countering excess optimism about a firm’s prospects.
