Short Selling

Short selling, also called “shorting” or “being short”, is an investment or trading strategy that speculates on the decline in a stock or other security’s price. It involves borrowing shares of the asset from a broker, selling them at the current market price, and then repurchasing them later at a lower price to return to the lender. The short seller profits if the price of the stock falls.

Mechanics of Short Selling

1. Borrow Shares: The investor borrows shares of the stock from a broker.
2. Sell Shares: The borrowed shares are sold at the current market price.
3. Buy Back Shares: The investor later buys back the shares at a lower price.
4. Return Shares: The shares are returned to the broker.
5. Profit Calculation: The difference between the selling price and the repurchase price, minus any borrowing costs or fees, represents the profit.

Example of short selling

Suppose an investor believes that the stock of Company XYZ, currently trading at $50 per share, will decline in the near future. The investor decides to short sell 100 shares of XYZ.

1. Borrow and Sell Shares:

• • Shares borrowed: 100
  • Selling price: $50 per share
  • Total proceeds from sale: 100 shares * $50 = $5,000

2. Price Declines:

• • The price of XYZ falls to $30 per share.

3. Buy Back Shares:

• • Repurchase price: $30 per share
  • Total cost to repurchase: 100 shares * $30 = $3,000

4. Return Shares:

• • The 100 shares are returned to the broker.

5. Profit Calculation:

• • Initial proceeds from sale: $5,000
  • Repurchase cost: $3,000
  • Gross profit: $5,000 – $3,000 = $2,000

Key Points

1. Profit Potential: The maximum profit occurs if the stock price drops to zero. In the example, if XYZ’s price fell to $0, the repurchase cost would be $0, and the profit would be $5,000.
2. Unlimited Risk: The potential losses are unlimited because the stock price can theoretically rise indefinitely. If the price of XYZ increased to $100 per share, the repurchase cost would be $10,000, resulting in a $5,000 loss.

Risks and Considerations:

1. Market Risk: If the stock price rises instead of falling, the short seller faces potentially unlimited losses.
2. Margin Requirements: Brokers typically require short sellers to maintain a margin account and meet specific margin requirements.
3. Borrowing Costs: Short sellers must pay interest on the borrowed shares, which can eat into profits.
4. Short Squeeze: A situation where a heavily shorted stock’s price rises sharply, forcing short sellers to buy back shares at higher prices, further driving up the price.

Real-World Example: Volkswagen Short Squeeze

Background: In 2008, Volkswagen (VW) experienced a famous short squeeze. Many investors were shorting VW shares, betting that the price would fall. However, Porsche announced that it had acquired a significant stake in VW, leading to a sharp increase in VW’s stock price.

1. Initial Short Position:

• • Suppose an investor shorted 1,000 shares of VW at €200 per share.
  • Proceeds from sale: 1,000 shares * €200 = €200,000

2. Price Increase:

• • Following Porsche’s announcement, VW’s share price soared to €1,000 per share.

3. Forced Buyback:

• • To cover the short position, the investor had to buy back the 1,000 shares at €1,000 per share.
  • Repurchase cost: 1,000 shares * €1,000 = €1,000,000

4. Loss Calculation:

• • Initial proceeds from sale: €200,000
  • Repurchase cost: €1,000,000
  • Loss: €1,000,000 – €200,000 = €800,000

In this real-world example, the investor faced an €800,000 loss due to the short squeeze.

Summary

Short selling is a high-risk, high-reward strategy that bets on the decline of a stock’s price. While it can lead to significant profits if the price falls, it also carries the potential for unlimited losses if the price rises. Investors must carefully consider the risks, costs, and market conditions before engaging in short selling.