Too embarrassed to ask: what is short selling?

Short sellers are often accused of unfairly driving share prices down to make a quick buck. But short selling is a perfectly legitimate – if risky – tactic. Here’s what short selling involves.

When most investors put money in the stock market, they go “long”. That is, they buy shares in the hope that the price 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 short seller borrows the shares from someone who already owns them (usually a fund manager) – the fund manager is happy to lend the shares to the short seller, because they get a fee in return for the loan. The short seller then sells these shares in the open market. If things go according to plan, the share price falls and the short seller can then buy the shares back at the lower price, return them to the lender, and pocket the profit.

So, for example, say you want to bet that the share price of Dodgy Widgets plc is heading for a fall. You borrow 10,000 shares from a friendly fund manager, and sell them at £1 a share. So you now have £10,000, but you owe the fund manager 10,000 shares. Thankfully, Dodgy Widgets 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 keep your £2,000 profit (less your borrowing fee).

Professional short sellers try to hunt down companies with weak business models, and bet against them. Managements don’t like being challenged in this way, so short sellers are often maligned. But in fact they provide a valuable service, and sometimes help to reveal the truth about an overhyped or downright fraudulent company.

Shorting is also far riskier than being “long”. If you buy a share, then the worst that can happen is that the share price goes to zero, and you lose all of the money you invested. But with short selling your losses are technically unlimited, as there is no ceiling on how high a share price can rise.

In our previous example, if Dodgy Widgets hadn’t warned on profits, but instead said that it was set to make much more money than expected, sending the share price higher, then our short-seller would still have to buy the shares back in order to return them. In this case, they would be looking at a hefty loss.

To learn more about short-selling, subscribe to MoneyWeek magazine.

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