The lowdown on short-selling

A guide to short-selling:

What is short-selling?

Short-selling is when an investor believes that the price of an asset, such as shares, currencies or oil contracts, is going to fall, and agrees to sell that asset in the relevant market at a certain price - without having actually purchased the asset. The deal will require another party, who believes that the price of the asset is going to rise, to purchase the shares or currency.

How can you sell something you don't own?

Instead of actually buying shares, investors "borrow" the asset they wish to short, normally from a broker. In order to do this, the broker will require the short-seller or borrower to create a "margin account", into which they must deposit a minimum proportion or "margin" of the value of the transaction, normally about 25 per cent.

If that's short-selling, then what does "going long" mean?

When an investor "goes long" on a stock, it means that they expect the price of the stock to rise in the future, and are therefore buying the stock to hold onto it. This is the most conventional method of buying shares.

How does an investor make money?

The investor is taking a punt on the price of the asset falling. If it does fall, they then cover their position by purchasing the asset at the new lower market price and benefits from the difference in purchase and sale price.

For example, an investor shorts (ie borrows and agrees to sell) 10,000 shares of ABC plc, which is valued in today's market at €5/share or € 50,000 in total, as he believes the share price will fall.

Two days later the short seller is proved right when the share price falls to €4. So the investor goes into the market and purchases 10,000 shares for a total price of €40,000. Having agreed to sell the shares at €50,000, the investor can now pocket a profit of €10,000. The maximum potential upside for an investor in a short trade is a 100 per cent gain, as the price can never fall below zero.

Is making money the sole purpose of short-selling?

While some investors will use short-selling solely to take a bet on the direction of a stock, it is more commonly used by sophisticated money managers such as hedge funds to "hedge" their position - ie, to offset possible adverse price movements in a related asset.

How long does a short trade last for?

Generally, investors can hold a short for as long as they want, but they may be forced to cover their position - ie, actually purchase the stock - if the broker wants the stock that was borrowed back. This is termed being "called away" and it doesn't happen very often.

I'm still not sure how it works - are there any famous examples of short-selling?

In 1992, one of the founders of the first hedge funds, George Soros, "shorted" sterling by risking $10 billion that the value of the currency would fall. Soros eventually made a reported $1 billion from the deal, and was said to have "broken the Bank of England" when, as a result of his trades, the bank was forced to devalue the currency and withdraw it from the European Exchange Rate Mechanism.

$1 billion - that sounds good. But are there any risks?

While, as the above example shows, the rewards of short-selling can be immense, the losses can also be eye-watering. If Soros had got his prediction wrong, he could have been out of pocket to the tune of $2 billion, or even more. Unlike when an investor goes long on a stock, in a short sell, the losses can be infinite, which makes shorting stock very risky indeed.

In the above example of how to make money on a short-sell, if the share price of ABC plc had risen by a fifth instead of falling by that proportion, the investor would have lost € 10,000.

If it was the case that the price had risen by a half, the short-seller would have lost € 25,000, and if the price had doubled, for example on the back of the discovery of a new wonder drug, the investor would be down € 50,000 - and so on.

I've heard of something called "naked" short-selling. What's that?

This is when the short-seller doesn't even borrow the asset that they are betting against. When the time comes the short-seller simply goes into the market and buys the asset to settle their position.