What is short selling?
Short selling, also known as 'shorting' or taking a 'short' position is an investment strategy based around aiming to profit from a falling share price. It's the opposite to the more conventional 'long' position, where investors profit from a rising share price.
To take a short position, investors will borrow the shares from a stockbroker or investment bank and quickly sell them on the stock market at the current market price.
If the share price falls, as they've predicted, they'll buy the shares back at a lower price and return the shares back to their original home. Short sellers aim to profit from the difference between the price they sell at, and the price they buy back at.
How does short selling work?
Short selling works in the opposite way to traditional investing – investors profit when their chosen investment falls in value and lose out when it rises. Let's take a look at two examples.
Short selling for a profit
Let's say you decide to borrow shares in ABC plc from a broker and sell them on the market when they were trading at £2.00.
One month later, the share price has now dropped to £1.50 – offering the chance to profit from a lower share price.
You could then buy the shares back on the market at £1.50, return them to the broker and pocket the difference (50p), less any trading fees.
Short selling for a loss
Using the same example as above. Let's imagine you decided not to buy the shares back at £1.50 as you thought they'd fall further.
However, ABC plc announce they've received a takeover bid for the company and the shares instantly jump to £2.50.
If you decided to cut your losses and sell at this price, you'd be down 50p per share (plus any trading fees).
Understanding short selling
Short selling as a tactic can be split into two parts – speculating and hedging.
Speculators take part in short selling as an advanced way to profit from negative movements in a particular share or sector. It's a high-risk strategy which requires precise timing and a stroke of luck.
Short selling as a speculator also has the potential for unlimited losses.
Share prices have a bottom, that means you can only lose what you invest with traditional investing. But share prices don't have a roof. They can technically rise to infinity – that's what makes short selling so problematic if you get your predictions wrong. Your potential losses are unlimited.
Aside from speculating, short selling is more commonly used to 'hedge' - minimise the risks of investing. I'm sure we've all heard the phrase 'hedge one's bets' before?
It's a strategy practiced by professional sophisticated investors like hedge funds, pension funds and insurance companies – basically people that buy investments in large amounts.
Short selling as a hedge can help soften the blow of an unexpected decline - an insurance safety net if things go wrong. That way, short positions can shave some of the profits off a long position, but they also keep the fund from big losses during a market downturn.
What it means for investors
Short selling as part of a calculated strategy to minimise risk makes sense for some institutional investors. But as an opportunity to profit from a stock market decline, it is very high risk.
We think the risks that come with shorting ultimately aren't worth the potential gains for retail investors – particularly when you take trading fees into account.
No one should invest more than they're willing and able to lose. Short selling can leave you nursing much larger losses than you had expected and even more than you originally invested.
Shorting as a short-term investing strategy is heavily time intensive too. Unless you've got buckets of time and access to high-tech trading technologies, you could be better off positioning your portfolio towards long-term investments.
