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.

Recommended

Great frauds in history: Jeff Carpoff’s green Ponzi scheme
People

Great frauds in history: Jeff Carpoff’s green Ponzi scheme

Jeff Carpoff's plan to make money from renting out solar-powered generators quickly turned into a Ponzi scheme.
4 Mar 2021
Too embarrassed to ask: what is fiscal drag?
Too embarrassed to ask

Too embarrassed to ask: what is fiscal drag?

How can politicians raise more tax revenue, without damaging their political popularity too badly? One way is by using “fiscal drag”. Here's what that…
2 Mar 2021
Why the classic 60/40 investment portfolio may no longer work
Investment strategy

Why the classic 60/40 investment portfolio may no longer work

The dramatic events in the bond market have thrown into question the classic investment strategy of the last 40 years. An investment portfolio made up…
1 Mar 2021
Expect more turbulence as the market calls central bankers’ bluff
Stockmarkets

Expect more turbulence as the market calls central bankers’ bluff

With bond yields climbing and stockmarkets sliding, markets are hoping central bankers will step in again to repress interest rates – but that won’t …
26 Feb 2021

Most Popular

A beginner’s guide to bitcoin: how to buy bitcoin
Bitcoin

A beginner’s guide to bitcoin: how to buy bitcoin

For the novice, buying bitcoin can be a daunting prospect. Here, Dominic Frisby outlines the process from start to finish.
3 Mar 2021
A beginner’s guide to bitcoin: what is bitcoin?
Bitcoin

A beginner’s guide to bitcoin: what is bitcoin?

As a completely novel concept for many people, bitcoin can take a little effort to get to grips with. In the first of a short series on the cryptocurr…
1 Mar 2021
Why gold has been such a bad investment so far this year
Gold

Why gold has been such a bad investment so far this year

Gold – the ultimate safe haven investment – is proving anything but safe. It’s lost over $200 an ounce since its high at the start of the year. Domini…
3 Mar 2021