What is Short Selling?

Short selling is an investment strategy that is opposite to the conventional stock investment strategy. Under normal circumstances, most investors will make profits from rising stock prices, so they will buy low and sell high. Short selling, on the other hand, is to make profits from falling stock prices , by selling high and buying low.

Short selling is often used to hedge investment risks so that profits can be maintained when stock prices fall. Some investors also use hedging to make speculative investments and may use unethical means to suppress stock prices in order to obtain high returns.

Because stock prices often fall faster than they rise, some speculators can earn high returns from short-selling if they make accurate judgments. However, the risk of short-selling is much higher than that of long-selling, because the lowest value of stock price decline is limited, but the price increase is unlimited. Therefore, short-selling requires investors to have high trading experience and investment vision. The most famous short-selling success is Michael Burry, the value investor who predicted the 2008 economic crisis.

What is short selling?

The basic concept of short selling is that investors borrow stocks from brokerage firms when stock prices are high, sell them at the same time, and then buy back the same number of stocks after the stock prices fall, and return the stocks to the brokerage firms to earn the difference in stock prices. The operation of buying back stocks from the market is called “Buy to Cover” in English.

For example, an investor borrows 10 shares of stock A at a price of $100 from a securities dealer and sells it to the market at a price of $100. When the price of stock A drops to $50, the investor buys back 10 shares of stock A from the market and returns the stock to the securities dealer. At this time, the investor earns $50 per share, a total of $500.

The opposite of short selling is long trading, which is the most common type of stock investment transaction. Investors buy stocks when they think the price is low to establish a long position, then wait for the stock price to rise, and sell it when it rises to the ideal price, earning the difference in stock price.

In practice, investors need to perform the following operations:

Apply to open a margin account, open a short position, and obtain institutional stock investment.

At the same time, a maintenance margin is deposited. The maintenance margin ratio is set by the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange (NYSE) and the Federal Reserve, and is usually at least 50% of the value of the short position. During the transaction, investors must always keep the balance in their account higher than the maintenance margin amount, otherwise their positions will be forcibly closed.

During the stock intervention period, investors need to pay interest on the borrowed stocks to the lender.

When the stock price drops to a desired level, the investor can buy the stock and return it to the lender, earning a profit after deducting all interest, commissions, and other fees.

Three important indicators to pay attention to when shorting

It should be noted that it is impossible to use only one or several indicators to judge the changes in stock prices. Please summarize more during the learning process and find your own judgment method.

When making short trades, you need to pay attention to three important short indicators:

Daily Short Volume : refers to the daily publicly traded short volume. For US stocks, this data is provided by the New York Stock Exchange.

Short Interest or Short Float : refers to the total number of stocks that are shorted. It is often expressed as a percentage (%), which is the total number of stocks currently shorted divided by the total number of issued stocks.

Short Ratio : The ratio of the net short interest to the daily short volume, that is, the ratio of the above two indicators, indicating the average number of days that the shorted stocks are bought-to-covered, so it is also called Days to Cover Short in English. The calculation formula is Short Ratio = Short Interest / Daily Short Volume.

Michael Burry – The King of Short Selling?

Michael Burry is arguably the most successful short-selling profiteer.

Michael Burry suffers from mild autism, but this disease helps him to gain extraordinary concentration when studying and researching certain contents. When he found that he had great interest in financial investment during his medical studies, he dropped out of school to study financial investment and founded Scion Capital Fund in 2000.

After founding Scion Capital, he analyzed market trends through his unique financial perspective, achieved a 55% return rate in the first year of operation, and managed assets of up to US$600 million in 2004.

In 2005, Michael Burry predicted the impending crisis in the real estate industry and told his investors to short the real estate market. Eventually, the subprime mortgage crisis broke out in 2007 and the financial crisis broke out in 2008. Many banks and hedge funds collapsed due to these crises, but Michael Burry led his investors to earn billions of dollars in profits.

Michael Burry then closed Scion Capital in 2008. During the eight years, Scion Capital’s total return rate reached 489.3%.

Michael Burry became famous for profiting from short selling during the 2008 financial crisis. His experience was written into the New York bestseller “The Big Short” . At the same time, his experience during the 2008 subprime mortgage crisis was remade into a Hollywood movie “The Last Short”, which is translated into Chinese as “The Big Short” and is well known to the world.

Why do investors short stocks?

There are usually two purposes for entering into a short trade: hedging or speculation.

1. Risk Hedging

This is the most common purpose of short selling transactions. Investors buy stocks to establish long positions, hoping to earn profits through rising stock prices, while establishing short positions. In this way, if the stock price rises, investors can earn profits from long positions. If the stock price falls, investors can still earn certain profits from short positions to hedge the risks brought by price fluctuations.

2. Speculation

Because stock prices usually fall faster than they rise, some investors choose to short sell to speculate and profit. When they predict that a stock’s price will fall sharply in the near future, they borrow a large number of stocks at a certain price and sell them. When the stock price falls rapidly, they buy a large number of stocks and return them to the lender, thereby earning high returns quickly.

What are the advantages of short trading?

1. Hedge investment risks

The biggest advantage of short selling is that it can hedge risks. When investors invest in one or a group of stocks, they may face investment risks brought about by falling stock prices. If short selling is carried out at the same time, it can hedge the risk of falling stock prices. Regardless of whether the stock price rises or falls, it can guarantee a return on the investment.

2. Low initial cost

The initial cost of short selling is almost only the margin. After paying the margin, you can borrow the required stocks and then start short selling.

3. Leverage investment

Short selling can achieve the benefits of leveraged trading. The initial cost of investors is the margin amount, which is a certain percentage of the value of the borrowed stock, such as 50%. The maximum profit ratio of short selling can be close to 100%, that is, the stock price falls to nearly $0. For example, when an investor borrows stocks worth $10,000 and the margin ratio is 50%, the investor needs to pay $5,000. When the stock eventually falls to nearly $0, the investor can make a profit of $10,000 after buying back the stock and returning it to the lender, minus the initial cost of $5,000, that is, a profit of $5,000.

What are the disadvantages of short selling?

1. No limit on losses

Short selling is different from long selling. The maximum loss of long selling is your net investment. For example, if you invest $10,000 and buy Apple stock, if Apple stock is completely delisted, you will lose at most $10,000. However, the loss of short selling may be unlimited.

The loss from short selling comes from the rise in the target stock price, because short selling makes profits through the decline in stock prices. If the stock price rises, investors have to buy back the stocks at a high price and return them to the lender. At this time, the stock price difference becomes the investor’s main loss.

Since there is no upper limit to the rise of stock prices, there is also no upper limit to the losses faced by investors. At the same time, during the investment process, investors must always ensure that there is sufficient margin in their accounts, otherwise they will be forced to close their positions and suffer losses. In addition to stock prices and margins, short-selling investors also face the interest they need to pay for borrowing stocks. As the trading time increases, the amount of interest that needs to be paid will continue to accumulate. Therefore, in general, the risk of loss faced by short-selling investors is much higher than that of long-selling investors.

2. Forced liquidation

Since short selling involves borrowing stocks, you need to pay a certain amount of margin. However, if the stock price rises instead of falling, you will need to add more margin.

If you fail to add margin in time, your stocks will be liquidated, which is called “Margin Call” in English.

Especially when stocks with a very high short position ratio rise sharply, a large number of short positions will be closed, which will lead to further increases in stock prices and cause more liquidations.

3. Facing a Short Squeeze

When a stock is heavily shorted, as the short sellers begin to buy back the stock, the stock price will rise rapidly. At this time, a short squeeze may occur, that is, the short-selling investors’ profits are reduced or even losses occur due to the concentrated trading of other short-selling investors.