A look at short selling stock

Short selling is an arbitrage strategy, which involves the selling of an asset that is not owned by an investor. Investors use short-selling when they believe that a company’s sales are slowing and earnings will drop. However, this strategy is addressed to risk-takers and not to risk-adverse investors. The reason is that, historically, the stock market rises in value over time, but short-selling moves in the opposite direction of the market. Therefore, it requires precise timing, which is a difficult feat.

We assume that an investor instructs his broker to short sell the shares of company X. The broker will carry out the instructions by borrowing the shares from another client and selling them in the market at the current market price. If the stock’s market price declines, the investor covers the short position by buying back the shares, which are then returned to the lender. The difference between the price the investor sells the security and the price he pays to buy it back, minus commissions and expenses for borrowing the stock is the investor’s profit. If the stock’s market price increases there are unlimited potential losses.

Example

To illustrate the example with numbers, we assume that an investor holds 400 shares of company X and decides to short them in February when the share price is $100. The short position is closed by buying the shares back in June when the price per share is $80. We also assume a dividend of $2 is paid in April. Since the price per share declined, the investor will receive profit.

To calculate the net gain we need to calculate the difference between the cost of buying the shares in February and the return received from selling the shares in June, minus the dividend paid in April. Therefore, the net gain is:

(400 x $100) – (400 x $80) – (400 x $2) = $40,000 – $32,000 - $800 = $7,200

Illustration of closing the sort position

Purchase of shares

February: Purchase of 400 shares for $100 = 400 x $100 = - $40,000

April: Dividend $2 per share = 400 x $2 = $800

June: Sell 400 shares for $80 = 400 x $80 = $32,000

Net gain = $32,000 + $800 - $40,000 = -$7,200

Short Selling of shares

February: Borrow 400 shares and sell them for $100 = 400 x $100 = $40,000

April: Pay Dividend $2 per share = 400 x $2 = - $800

June: Buy 400 shares for $80 to close the position = 400 x $80 = -$32,000

Net gain = $40,000 - $800 - $32,000 = $7,200

Implications from short-selling

Short-selling concerns typically rise when markets decline. The most popular targets of short-sellers are firms with small capitalization, which have been driven by momentum investors or firms with high P/E ratios and growth rates such as banks. The recent example of the collapse of Bear Stearns is a typical example of short-selling which occurred several months before the company collapsed and led other institutions to stop doing business with it, fearing it might be in trouble.

Another implication of short-selling is the allegations about the motives of short-sellers. Short-sellers are accused of driving down the stocks of several firms, by creating collusion and spreading rumours.

Conclusively, short selling is a particularly risk hedge strategy and it is far from being a financial panacea. It is a complicated strategy to execute, because in the long run stock markets tend to rise.