Definition and Uses of Short Selling Finance Essay

Short selling is generally understood to be the market practice of selling a financial instrument that the seller does not own at the time of the transaction [1].

To begin with, the seller, anticipating a fall in the price of an underlying security, borrows that particular security from a security broker at a lending fee. He then sells it on to a market participant at the market price in the initial period.

Next, the seller has to be able to return the borrowed securities to the broker at the time they are due. To do so, he buys the relevant number of securities at the market price in the second period and returns them to the broker.

The key rationale of short selling transactions lies in the expectation of falling prices and the decision of the short seller to try to benefit from the expected price development.

If the price of the security has fallen, then the short selling transaction turns a profit, leaving the short seller with net earnings equal to the price at the time of short selling the securities minus the price of the securities when covering his short position minus the fees he paid for borrowing the securities in the meantime.

As an example:

The short seller borrows 3000 Vodafone shares at a price of 150, selling at an overall price of £4500 on the open market.

The price of the security falls to 130 over the next fortnight.

The seller then buys the shares back on the open market for an overall value of £3900 and returns them to the broker.

The rationality pays off and the short seller makes a net profit of £600 (excluding transaction costs and financing fees).

The maximum profit a short seller can achieve from a short transaction is equal to the value of the asset sold short minus fees. In the extreme event of the market price of the asset falling to zero, the short seller can theoretically cover his transaction at zero cost, leaving him with the initial revenue from selling the asset minus the lending fees. The potential loss that the short seller risks, however, can be infinite. In case the market price of the asset sold short rises against the short seller's expectations, the costs of covering his short position rise in line, theoretically without limit. However, losses are usually contained as, in the event of rising prices, the short seller will be asked by the broker to either cover his position by buying the shorted asset, or to provide additional financing in order to meet the margin requirement for the security. The market risk is particularly high in case of a short squeeze. A short squeeze is a situation where the market price of an asset rises sharply as demand for the asset significantly exceeds its supply on the market, especially as a result of intense short sale covering. While short sellers expect market prices of an asset to fall, an actual increase in the price puts the short seller under pressure to cover their short position so as to minimise the loss on their short contracts. Also, short sellers may receive margin calls by their brokers. As short sellers seek to cover their positions they need to buy the underlying asset which causes its price to rise even further. This, in turn, may result in further waves of margin calls, asset purchases, and price rises. A memorable instance of a short squeeze occurred in October 2008 when the rush of short sellers to cover their positions led to the share price of car manufacturer Volkswagen AG to increase by more than 500% within only two trading days. The rise in the share price illustrates the severe impact short squeezes can have on market prices.

WHY SELL SHORT?

Given the risk profile of short selling strategies - i.e. the expectation of revenues from falling asset prices, limited profits, and virtually unlimited risks of loss - short selling is usually not pursued as an investment, but rather as a hedging instrument. Two motivations can be recognized:

Hedging of an existing exposure:

An investor owns an asset whose market price he expects to fall, and he decides to hedge against that risk. Examples of this include:

A strategic equity stake in a company which the investors wishes to hold on to despite the expected loss in market value.

Equity or other securities positions held by institutional investors - such as insurance or fund companies - which hold the assets as part of a defined portfolio, and may not be in a position to sell securities as portfolio strategies or compliance with regulatory portfolio allocation rules may discourage such disinvestments at short notice.

Producers of agricultural products or commodities find it useful to offset expected losses from falling prices in their businesses.

In all three examples, short selling can be an important and economically sensible instrument for compensating potential losses from asset price declines.

Benefiting from market trends:

Speculative motivations are the second objective for engaging in short selling strategies. Investors expecting the price of an asset to decline may choose to benefit from their assessment by short selling an asset to a counterparty who expects the opposite market development and is ready to enter a transaction on the basis of that expectation.

ADVANTAGES AND DISADVANTAGES OF SHORT SELLING

Pros

Short-selling activity accounts for approximately 25% of the total market turnover according to Diether et al (2009). This reflects the direct contribution of short selling to market turnover. However, short selling also generates additional trading indirectly, as liquidity brings about more liquidity. Additionally, short selling improves market efficiency and helps attract more trading as follows:

Short-selling activity helps price discovery. For instance, it reflects negative information to the market, which in turn generates more trading interest and hence increased trading in the overall market.

Short selling also facilitates professional investors such as hedge funds, which may adopt certain strategies involving short-selling, i.e. the long/short strategy.

Short selling contributes to trading in the derivatives market which can in turn contribute to cash market activity. It is commonly used by market makers of stock options and stock futures to hedge their market-making positions.

All these effects are considered to add to the efficiency of financial markets.

Cons

There are many disagreements and general detestation of short-selling; some say that it even reduces market efficiency. Reasons include:

Amongst the principal costs, short selling can aid price manipulation as short sellers can expand the supply of shares, temporarily depressing prices and profiting from the fall.

Moreover, naked short selling can result in failures to deliver, which create 'phantom stocks', diluting ownership rights, destroying shareholder value and threatening market integrity (SEC, 2008).

Short selling can be used in a possible attack on a large institution's stock price, undermining confidence in its solvency and threatening the financial system as a whole (the run on Sterling by George Soros is a prime example).

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