Going short

What Is Going Short?

Going short, also known as short selling, is an investment strategy within the realm of Investing Strategy where an investor speculates on the decline in a security's price. This involves borrowing shares of a stock or other financial instrument that the investor does not own, selling them at the current market price, and then repurchasing them at a lower price later to return to the lender. The goal of going short is to profit from the difference between the higher sale price and the lower repurchase price. This strategy is distinct from taking a long position, where an investor buys a security with the expectation that its value will increase. Short selling requires a broker-dealer to facilitate the borrowing of shares and typically involves a margin account.

History and Origin

Short selling has a long and somewhat controversial history, dating back centuries. One of the earliest documented instances is often attributed to Isaac Le Maire in the early 17th century, who famously shorted shares of the Dutch East India Company. The practice evolved as financial markets became more sophisticated, providing a mechanism for investors to capitalize on declining asset values or hedge existing long positions.

Regulation of short selling has also developed over time. In the United States, significant regulatory efforts began following the stock market crash of 1929. The Securities and Exchange Commission (SEC) introduced rules like the "uptick rule" in 1938, which generally allowed short sales only when the last trade was at a price higher than the previous trade. While the specific rules have changed, such as the repeal of the original uptick rule in 2007 and the introduction of a circuit breaker rule in 2010, the SEC continues to oversee short selling through regulations like Regulation SHO, enacted in 2005. Regulation SHO was designed to address concerns about abusive "naked" short selling and persistent failures to deliver securities¹¹, ¹². This regulation mandates that broker-dealers locate securities to borrow before executing a short sale and imposes requirements to close out failures to deliver¹⁰.

Key Takeaways

• Going short, or short selling, is a strategy to profit from an anticipated decline in a security's price.
• It involves borrowing shares, selling them, and later buying them back at a lower price to return to the lender.
• Short sellers are exposed to unlimited potential losses if the price of the security rises indefinitely.
• The strategy can be used for speculative purposes or for hedging against existing long positions.
• Regulation SHO governs short selling in the U.S., requiring a "locate" of shares before a short sale.

Formula and Calculation

The profit or loss from going short is calculated based on the difference between the price at which the shares were initially sold and the price at which they were later repurchased, minus any associated costs such as borrowing fees and commissions.

The formula for profit (P) or loss (L) from a short sale is:

For example, if an investor sells 100 shares of Company A at $50 per share and later buys them back at $40 per share, with total borrowing costs of $50, the profit would be:

This calculation demonstrates how the investor benefits when the share price declines. The borrowing costs can significantly impact the overall profitability of the trade.

Interpreting Going Short

Going short is primarily interpreted as a bearish outlook on a particular security or the broader stock market. When investors go short, they are betting that the price of an asset will fall, often due to perceived overvaluation, deteriorating company fundamentals, or negative industry trends. A high volume of short interest in a stock can sometimes signal that a significant number of sophisticated investors believe the company's prospects are dim. Conversely, a reduction in short interest might indicate that bearish sentiment is waning or that short sellers are covering their positions. For market participants, understanding the level of short interest in a stock can provide insights into prevailing market sentiment.

Hypothetical Example

Consider an investor, Sarah, who believes that Tech Innovations Inc. (TII) is overvalued and its stock price of $100 per share is likely to fall. Sarah decides to go short on TII.

1. Borrowing and Selling: Sarah instructs her broker to borrow 200 shares of TII, which she then sells on the open market at the current price of $100 per share. This generates $20,000 in cash. This cash, along with additional collateral, is held in her margin account.
2. Price Decline: As Sarah predicted, TII announces weaker-than-expected earnings, and its stock price drops to $70 per share.
3. Repurchasing and Returning: Sarah decides to close her position. She buys 200 shares of TII at the new market price of $70 per share, costing her $14,000.
4. Profit Calculation: She then returns the 200 shares to the lender. Assuming borrowing fees of $100, her profit from the short sale is:
   • Initial Sale Revenue: $20,000
   • Repurchase Cost: $14,000
   • Gross Profit: $6,000
   • Net Profit (after fees): $6,000 - $100 = $5,900

This example illustrates how going short can yield a profit when the asset's value decreases.

Practical Applications

Going short has several practical applications in financial markets beyond pure speculation. One primary use is hedging. For instance, an investor holding a diversified portfolio might short an index exchange-traded fund (ETF) to protect against a potential downturn in the overall market, without having to sell individual long positions. This strategy aims to offset potential losses from the long positions with gains from the short position.

Another application is in arbitrage strategies, where investors seek to profit from temporary price discrepancies between related securities. This might involve simultaneously buying an undervalued asset and going short on an overvalued, related asset. Short selling also plays a role in providing liquidity to the market by enabling sellers to sell shares they do not yet own, thereby meeting demand. However, the use of short selling came under scrutiny during events like the GameStop short squeeze in 2021, where a coordinated effort by retail investors to buy shares caused massive losses for hedge funds with significant short positions⁷, ⁸, ⁹. Such events highlight the dynamic and sometimes volatile nature of markets when short interest is high.

Limitations and Criticisms

While going short can be a powerful strategy, it carries significant limitations and risks. Unlike a long position, where potential losses are limited to the initial investment, the potential losses from going short are theoretically unlimited. If the price of a shorted stock rises indefinitely, the short seller's losses will also continue to mount. This necessitates robust risk management practices.

Critics also argue that aggressive short selling can contribute to excessive market volatility or even facilitate market manipulation by driving down a company's share price unfairly, especially during periods of market stress. Historically, regulators have imposed restrictions on short selling during financial crises to prevent such effects. For example, during the 2008 financial crisis, the SEC temporarily banned short selling in financial stocks due to concerns about market stability⁶.

Academic research, however, offers a more nuanced view. Studies suggest that short selling can actually improve price efficiency by allowing negative information to be quickly incorporated into stock prices⁵. This contributes to more accurate valuations and can deter fraudulent activities by exposing overvalued companies. A study from the Federal Reserve Bank of Cleveland, for instance, found no evidence that short selling of bank stocks materially led to larger outflows of bank deposits, despite some arguments to the contrary during bank failures⁴. Nonetheless, the high-risk nature of going short and its potential impact on investor confidence remain points of ongoing discussion and regulatory consideration within financial circles.

Going Short vs. Long Position

The fundamental difference between going short and taking a long position lies in the investor's market outlook and the direction of their anticipated profit. When an investor takes a long position, they purchase a security with the expectation that its price will increase over time. Their profit is realized when they sell the security at a higher price than their purchase price. The risk in a long position is limited to the initial capital invested, as the lowest a stock price can go is zero.

Conversely, going short involves selling borrowed securities with the expectation that their price will decrease. The profit is realized by buying back the securities at a lower price to return to the lender. The risk profile of going short is inverse to that of a long position; while potential profit is limited (as a stock price cannot fall below zero), potential losses are theoretically unlimited because there is no cap on how high a stock's price can rise. This core distinction shapes the strategies, risks, and regulatory frameworks associated with each approach.

FAQs

Why do investors go short?

Investors go short primarily to profit from an anticipated decline in a security's price. They might believe a company is overvalued, has poor future prospects, or they may use it as a way to hedge against potential losses in other investments.

What is a "naked" short sale?

A "naked" short sale occurs when a seller sells shares without first borrowing them or confirming that they can be borrowed. This practice is largely restricted by Regulation SHO in the United States to prevent artificial downward pressure on stock prices and address failures to deliver securities², ³.

Can going short result in unlimited losses?

Yes, unlike buying a stock (long position) where your maximum loss is your initial investment, going short carries the risk of unlimited losses. This is because there is no theoretical limit to how high a stock's price can rise, meaning the cost to buy back the borrowed shares could far exceed the initial sale price.

Is short selling legal?

Yes, short selling is generally legal in regulated markets. However, it is subject to specific rules and regulations, such as the SEC's Regulation SHO in the U.S., which requires a broker-dealer to have reasonable grounds to believe the security can be borrowed and delivered before a short sale order is executed¹. These regulations aim to maintain market integrity and prevent abusive practices.