When most investors put money in the stockmarket, they go “long” – they buy shares in the hope that they will go up. Short selling is the opposite of this – it’s a method of profiting from a share price going down. Here’s how it works. A shortseller borrows the shares from someone who already owns them (usually a fund manager), and sells them in the open market. Then, if and when the price falls, the shortseller buys the shares back at the lower price, returns them to the lender, and pockets the profit.
So for example, say you want to sell shares in Acme Widgets short. You borrow 10,000 shares from your local index fund provider in return for a small fee, and sell them at £1 a share. So you now have £10,000 (less your borrowing cost) but you owe the index fund 10,000 Acme shares. Thankfully, Acme issues a profit warning later that month, and the share price falls to 80p per share as a result. You buy 10,000 shares back for £8,000. You return the shares, and enjoy a £2,000 profit.
That’s the mechanics. So why would you do it? Professional shortsellers try to hunt down companies with weak or even fraudulent business models, then bet against them. Shorts are often maligned, partly because company managements find them a convenient scapegoat, but shortsellers in fact provide a valuable service – sometimes helping to reveal the true state of an otherwise overhyped stock.
Shorting is also extremely risky and not something to be done lightly. If you buy a share, then the worst that can happen is that it goes to zero, and you lose 100% of your money. But with short selling your losses are technically unlimited, as there is no ceiling on how high a share price can rise. Also, in practice, spreadbetting is the only practical way for most retail investors to go short. This incurs the additional risk of being highly leveraged (in other words, you are betting with borrowed money), which magnifies any losses.
• Watch Tim Bennett’s video tutorial: Why are short-selling ban won’t work.