What are the Pros & Cons of Short Selling

Pros and cons of short selling

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Bull and bear markets are the yin and yang of financial cycles. Learning to short sell may prove to be lucrative.

When people think of short selling, they associate it with financial vultures, unscrupulous hedge funds, and doom merchants. Even regulators are not too kind towards this activity. Banning short-selling activities is the first thing they do during market panics. But is short selling really that negative?

In a modern, sophisticated and complex financial market, short selling is an invaluable activity. It helps to burst unfounded optimism of a sector, prevent irrational buying of assets, and uncover frauds plus other financial shenanigans. It is a vital part of an efficient market and price discovery.

If you want to short the market you can compare brokers for going short here.

What is short selling and what are the risks?

Short selling is taking a punt on the downside of a stock. To short sell a stock, you borrow shares from someone who already owned them, and sell these shares on the market hoping to back them back cheaper in the future. For example, you borrow XYZ plc shares and sell them at 120p now. If prices go down to 100p next week, you make a 20p gain.

After you buy back the stock, you return these shares back to the original owners.

Unlike buying shares, short selling is not cheap. On top of the usual CFD or spread betting brokerage fees, short sellers may have to pay a fee to the owners of the shares and whatever dividends accrued to them during the period shares out on loan.

Moreover, short selling is fairly high risk. This is because a stock’s upside is limitless. The most XYZ plc can only go down is 100% (bankrupt). But it can double or triple over a short period of time. Thus brokers who arranged the shares often require counterparts to post large collateral to guard against this risk.

But this is not the most crucial factor. The most dangerous risk for CFD traders short selling is a short squeeze. This describe a manic scramble to buy back shares previous shorted. The catalyst could be better-than-expected results, a takeover approach, or a new product discovery. Suddenly, every short seller rush to cover their short positions by buying back the shares they previously shorted. When everyone buys a stock, it creates an immense upward pressure on prices which hurt short sellers even more.

One recent example is Tesla (TSLA), which was heavily shorted in 2018-’19. But when its financial position was not as dire as predicted, Tesla began to surge – and prompted a massive wave of short covering. The spike to near $1,000 indicates this panic buying. Once this wave passes, prices collapsed back to $400. That’s why naked short selling is often limited to experienced and sophisticated investors with deep pockets.

Why you should consider short selling

  1. Short selling could be suitable for some astute investors who enjoy going against the grain. It is a lucrative activity for successful investigative traders who know that they are doing. There are professional funds that are dedicated to this activity alone.
  2. Short selling pays off just when you need it. For example, your short selling activities may net you a fortune during a severe bear markets. This gives you a layer of protective blanket on your long-only portfolios.
  3. Short selling allows you take more aggressive long activities because you have some downside hedge.
  4. There are plenty of opportunities for short sellers in the UK. During a relatively steady year (2019), there are many blue-chip FTSE stocks that plummeted in value.  For example, Centrica (CNA), Fresnillo (FRES), Glencore (GLEN) all drop by double digits (see below). This create opportunities for short sellers.

Three scenarios when you should consider short selling

Broadly speaking, there are three scenarios where short selling can be considered.

Speculative Mania. When stock markets have been rising to stratospheric levels and  incredibly expensive valuation, it is ripe for short selling. One instance that comes to mind is the dot-com boom. Many stocks slumped by 99% in the crash that followed. Not to forget is that during the Global Financial Crisis in 2008 many short sellers made a fortune because they bet against the credit bubble. One key thing to bear in mind is that selling a mania requires a near-perfect timing. An expensive stock can become even more expensive before prices turn down.

Undiscovered Fraud. This means that investors are generally unaware of the underlying ill financial health of a company. One recent example in the UK is NMC Health (NMC), a former darling of the stock market. In December of 2019, the company was accused by Muddy Waters – a specialised research outfit that targets financial frauds – for concealing its true debt levels. Initially, the firm rejected these accusations. Then the true picture emerged weeks later and NMC was suspended, but not before its share prices collapsed by 75% from its peak (see below). If you smell something fishy about a stock, stay away. Better still, short sell it.

Bear Markets. During a bear market, most stocks will depreciate. Prices decline as profit outlook turn negative. Valuation of a stock shrinks. This means that the path of least resistance is to the downside, create trends that are favourable to short sellers.

Stacking the odds on short selling

Given that short selling is risky, you should gather as much favourable conditions as possible before embarking selling a stock. Below are a few factors that may increase your success

  1. Know the company inside out, especially if you are short selling individual stocks. You need to be able to ascertain a company’s true financial picture better than the market. Not easy to do, given markets are relatively efficient. Seek discrepancies in the firm’s debt, cash flow, product sales, etc – and compare it with its peers. Does it make sense? Is high valuation a reason to short sell it?
  2. Look for triggers. Shorting a stock on its way up is highly dangerous because you may not have the financial power to sustain margin calls. Better to wait until prices peak and start to come down. During the dot-com, one trigger to short a stock was the expiration of lock-up periods. When these lock-up expired, management, early investors, and founders all dump their stock holdings to turn their paper wealth into cash. This created massive downward pressure on prices.
  3. Start small. Only add when prices are starting to move favourably in your direction. Stoplosses are essential.
  4. Analyse short activities. Find out what other funds are shorting – because this may create herding behaviour (see below).

Where can you find short selling activities in the UK?

Financial Conduct Authority (FCA) has this highly useful website that detailed short positions on stocks. The data is in an excel format.

For example, recently Premier  Oil (PMO) is the most highly shorted stock – unsurprisingly due to its vulnerable share price. Others like Easyject (EZJ) is also heavily shorted because of the collapse in air travel.

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