Educational Piece: Short-selling simplified

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“I cannot get my head around short selling, so maybe that could be a future topic to do an educational piece on. Your take on this will be appreciated.” - Stephen

Short selling has been the #1 most common educational-piece request I’ve received in the last few weeks. So in this educational piece, we'll demystify short selling, explain its purpose, and explore how it can be used by everyday retail investors on the ASX.

Short selling in two sentences:

Traditional investing (buying long) allows you to profit when a company’s price goes up. 

Short selling allows you to profit when a company’s price goes down. 

How does that actually work?

Short selling can be broken down into two simple steps:

1. Opening the short: To execute a short sale, an investor opens a short position. 

   1. This effectively ‘borrows’ shares from a broker or another investor. 

   2. The borrowed shares are sold immediately in the market. 

2. Closing the short: The investor waits for the stock price to decline. 

   1. Once it reaches a desired lower price, they close their short position, which effectively ‘repurchases’ the share at a lower price than they initially ‘borrowed’ it for. 

   2. The investor then pockets the difference between the initial sale price and the repurchase price as their profit.

Why Does Short Selling Exist?

Short selling may initially seem counterintuitive since it involves profiting from a company's declining stock price. However, it serves important purposes in the financial ecosystem:

• Price Discovery: Short sellers provide an alternative viewpoint by identifying overvalued stocks, which helps correct market inefficiencies and facilitates price discovery.

• Risk Management: Short selling allows investors to hedge against potential losses in their long positions, acting as a form of insurance in bear markets.

• Market Liquidity: Short selling enhances market liquidity by adding more potential buyers and sellers, improving overall market efficiency.

Applying Short Selling as a Retail Investor

Short selling requires specific broker permissions and restrictions for retail investors, as it has more potential downside losses than regular long selling. Think about it, if you buy something, the worst that can happen is it goes to $0 and you lose your entire investment. If you short a stock, the price can keep rising (theoretically) forever…making your loss bigger and bigger. Strict discipline for exiting a position is required. 

Exchange-traded-products like the Betashares Australian Strong Bear fund (ASX: BBOZ) can provide easier access for retail investors. In the case of these products, you’re not directly shorting a stock, but rather you’re investing in a fund that does the shorting for you. 

ASX 200 vs. BBOZ (Source: Market Index

Risks of Short Selling

• Unlimited Losses: Unlike traditional investing, where losses are capped at the initial investment, short selling has unlimited loss potential. 

  • When you are long selling, if you buy a $100 stock and it goes down to $0, you cannot lose any more money. 

  • But if you’re shorting a stock that starts at $100, then goes to $200, $1,000, $10,000, etc - your losses have no capped downside. 

• Short Squeeze: In certain situations, when a heavily shorted stock starts to rise sharply, it can trigger a short squeeze. This occurs when short sellers rush to cover their positions and avoid further loses, which can drive the stock price even higher and cause substantial losses.

• Margin Calls: If the borrowed shares' value increases significantly, your broker may issue a margin call, requiring you to deposit additional funds to cover possible losses. 

To see the most shorted ASX stocks, and learn more about short selling, check out this page on Market Index.