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If you’re caught up in the unfolding GameStop story, you might be wondering how short selling works and how it’s possible for South African traders to profit from falling stock prices.
Short selling historically gets a bad rap in the investment world because traders are benefiting from a company’s loss. And if enough traders or fund managers short a stock, it sends a message to the market which can result in more selling hence sending prices lower.
However, not everybody believes short selling is bad. One argument is that it keeps the market running efficiently because short-sellers dig out companies that are “overvalued”. The strategy can also be used to offset losses during a stock market crash. This can be particularly useful for investors holding a portfolio of dividend shares that they’d prefer not to sell as prices fall.
While it varies from country to country, there are a few different ways to short sell stocks, from borrowing shares from a broker to trading put options and CFDs. We’ll give you an overview of what short selling means, how you can do it and the risks involved.
Important: Short selling is a controversial strategy and not everyone thinks it should be allowed. Some countries have banned it entirely. Either way you look at it, short selling is for experienced traders only.
What is short selling?
The idea behind this investment strategy is that if you think a stock’s value is going to decrease, you can make money out of it. You borrow the stock from a broker, sell it at the market price, buy it back when the price has decreased, then give the stock back to its legitimate owner and keep the profit.
A quick example: Say you think Spar’s stock price is going to fall today. You borrow 10 shares from that company that cost R200 each and sell them at market price (R200 x 10 = R2,000). It turns out that you’re right and by the end of the day, they’re worth R180 each. So you buy them back for less than you sold them (R180 x 10 = R1,800), then give them back to the broker. You keep the profit, which is R2,000 – R1,800 = R200. Even after the fee that you’ll have to pay to the broker for the stocks you borrowed, it’s a nice earning.
It sounds easy, but the problem is, things could also go the other way around. If it turns out that you were wrong, and at the end of the day 1 Spar share is worth R210 instead (R210 x 10 = R2,100), you’ll lose money (R2,000 – R2,100 = -R100).
Traditional short selling
The traditional means of shorting a stock directly is to contact a full-service broker or a major investment fund such as Investec. Full-service brokers usually offer advice alongside trading and they charge a premium price for the service.
In South Africa, the service is usually only available to wholesale investors and hedge fund managers, those that are either professional investors or are investing a minimum of around R 1 million.
The Financial Sector Conduct Authority (FSCA) wants to introduce stricter regulations around short-selling in South Africa, but for now there isn’t much regulation in this sector. Below is the traditional method for shorting a stock:
- Find a broker that offers short selling. Not all brokers will facilitate short selling and not all stocks will be available for borrowing, so you may have to do some research.
- Open a position to sell it. It will be bought at the market price and held under a contractual lending arrangement.
- Keep an eye on the price. Getting distracted is a bad idea. You need to be able to react quickly if things go wrong.
- Buy the stock back when you think it’s the right moment. You’ll need to find a good risk/reward balance. When things are going well, it’s easy to become too greedy and wait too long to buy back.
- Give the stock back and keep the profit (or sustain the losses). If the price goes down and you buy back for less, you’ll have made money out of your short selling. If the price goes up, you’ll lose money instead. Don’t forget that the risk is all on you.
Short selling through online trading platforms
Many traders prefer to short sell through online share trading platforms. In South Africa there are two key ways to do this:
- Contracts for difference. CFDs are derivative investment products that allow you to speculate on prices without actually owning the shares. This means that CFD traders can profit whether the prices of stocks, commodities or currencies are going up or down. Bear in mind, it pays to be aware that CFDs are complex and risky financial instruments and many investors lose money this way.
- Options trading. You can purchase an option on a stock that allows you to sell it at the initial market price within the option’s expiry date. If the price goes down, you sell, buy back at the new price and make a profit. If the price goes up, you don’t sell at all and only lose the value of the option, thus limiting the risk. With traditional short selling, you can buy back whenever you want (unless the owner of the stock claims it back), whereas options normally have a fairly short expiry date.
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Risks of short selling a stock
Repeat after us: short selling is for expert investors and you shouldn’t do it unless you do know what you’re doing.
The reason it’s considered so risky is that you could lose “infinite” money. When you buy a share and “go long”, the maximum you can lose is the amount you invested. When you “go short” instead, there are no theoretical limits to how much share prices could go up, and thus to how much you could lose.
It’s especially dangerous if a lot of people are short selling shares from the same company and the price unexpectedly goes up. At that point, everyone will start buying back quickly, causing the stock to go up even more. It’s what’s called a “short squeeze” and it easily becomes a vicious cycle that turns out very expensive for short-sellers.
Finally, don’t forget that short selling isn’t free. Brokers will charge a fee for lending stocks, and there are fees for other short-selling methods too. Be aware that these will partially lower your gains and increase your losses.
Protecting your portfolio
Say you hold a portfolio of stocks and you predict that a market crash is coming or a company’s stock is going to fall. To avoid losses to your portfolio, one option would be to sell the stocks of the companies that you hold before their prices drop – if you can get the timing right.
However, if you hold dividend stocks, you might prefer to keep them for the long run for the income. To avoid your portfolio falling in value (without selling the shares) you could short the stocks through a CFD or put options to the amount you think they will fall – and so offset any losses.
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