Short selling is back in the news with claims that hedge fund managers are shorting companies in anticipation of a no-deal Brexit.
Short selling - or shorting - involves selling shares you don’t own in anticipation that a stock will drop in value. This technique doesn’t only apply to stocks - currencies, options and other asset classes can all be shorted.
Typically, short selling is associated with speculative traders looking for short-term gains. Yet hedge funds and other investors short stocks to offset risk. For example, you might hold shares in one stock expecting it to gain over 5 years, but also short the stock to mitigate any short-term volatility - effectively having two opposing positions.
How do you short a stock?
Like traditional trading, profits from short selling come from the difference in a stock’s buy and sell price. Only instead of buying a stock, you borrow stock from a broker, which you then sell in anticipation of buying it back at a lower price.
For example, say Lloyds’ [LLOY] is trading at 50p a share. You think the stock is due to drop and borrow 1000 shares from a broker. Immediately you sell them for £500. Lloyds then announces underwhelming earnings results and the stock falls to 40p a share. You buy back the 1000 shares for £400, which you return to the broker. In the process, you’ve made a £100 profit from the difference in price.
You don’t always have to use a broker. Another way to short is to trade CFDs through an online trading company. The advantage is that you can use leverage to make your capital go further. As you don’t own the underlying asset there’s no stamp duty to pay.
What are the biggest short sells?
Investor Michael Burry made millions betting against mortgage securities before the 2008 financial crash. Burry was able to short the housing market by persuading investment houses, including Goldman Sachs, to sell him credit default swaps against subprime mortgages.
When the market collapsed, Burry made a profit of $100 million for himself and $700 million for his investors. However, shorting stocks isn’t Burry’s traditional trading technique:
"I don't go out looking for good shorts. I'm spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it."
“I don't go out looking for good shorts. I'm spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it” - Michael Burry
John Chanos is one of the most infamous short sellers. Chanos founded hedge fund Kynikos, which is Greek for ‘cynic’, and in his own words has seen “more stocks go to zero than infinity.” Chanos’s big short was against energy giant Enron in 2001. Spotting red flags in Enron’s accounting practices, Chanos shorted Enron just before the company collapsed, netting a $500 million profit.
Political events like Brexit can also be an opportunity for the canny short seller. In the run up to the EU referendum, City grandee Crispin Odey of Odey Asset Management placed large bets shorting sterling and government bonds. When the leave vote came through, sterling collapsed and Odey made off with a whopping estimated profit of £220 million.
John Chanos' profit after shorting Enron in 2001
What are the risks?
Short selling carries greater risk than conventional trading. Unlike speculating on a stock gaining in value, where you can only lose your initial investment, there’s no limit on losses. Theoretically, a stock can keep gaining in value, increasing the amount you will have to pay back.
The most notorious example of investors losing money shorting a stock is the Northern Pacific Corner of 1901. Shares in a railroad jumped from $170 to $1000 in a single day, bankrupting short-sellers who desperately tried to buy back shares.