Shorting

If there is one subject guaranteed to confuse and divide opinion among traders and non-traders alike, its shorting.

Shorting is the act of selling shares that you do not own to profit from them falling, rather than rising in value. It is done by borrowing the shares that you wish to short sell from your broker and then buying them back at a lower price.

If you have a traditional share trading account, shorting is extremely difficult to do, at least in the UK. Most traders of UK shares short shares using spread betting or CFD’s. Here is a quick spread betting example:

The price of M&S on my spread betting providers website is as follows:

366.78 – 368.25

In other words, I can buy a spread bet in M&S at 368.25 and sell a spread bet in M&S at 366.78. I currently do not own a spread bet in M&S at the time of writing but if my analysis of M&S concluded that its share prices was likely to go down, then I could short sell M&S at 366.78.

Let us assume that I shorted M&S at £10 per point, let us further assume that over the next three days M&S went down in value and my spread betting provider is now quoting the following for M&S:

360.52 – 361.99

In order to to make profit, I would need to close the short spread bet at 361.99.

The end result

The opening price of my short was 366.78 and the closing price was 361.99.

366.78 minus 361.99 = 4.79 points multiplied by £10 (per point) = £47.79 profit.

The common complaints I hear about shorting are that:

1. It is immoral. Traders should not be making money from companies who are losing money when those companies are struggling to keep hold of their employees and customers.
2. Shorting exacerbates the decline of the share price of the company being shorted. This was certainly the view of the Chancellor of the Exchequer during the financial crises, so much so, that he banned shorting for a while.
3. Shorting is a much more riskier form of trading than simply buying shares in the traditional way. It is gambling.

I take issue with all of these points of view. Take the first point. What if you are a share holder of a company whose share price was falling? Wouldn’t you want to short the company rather than sell your shares, especially if you believed in the company and wanted to remain a shareholder; shorting would allow you to hedge your position whilst allowing you to remain a shareholder and not lose money on the value of your shares. Also, if your perspective on the stock markets is ‘long only’/’no shorting here please’ then who will provide the shares for you to buy? Someone has to sell shares in order for them to be purchased.

Point two. Shorting can exacerbate the decline of a company’s share price. Lots of buying can also exacerbate the advance of a company’s share price. It has always amused me that short sellers are blamed for the collapse of companies because they are being shorted.

Another possibility as to why the share price of a company may be declining is bad management of the company by its officers. Now there’s a novel thought. Lets take a recent example. Over leveraged banks were heavily shorted during the financial crises and for good reason; company managers incentivised employees to take massive risks with people’s hard earned money. Money that was not theirs.

Point three. Shorting is risky for people who do not understand shorting in the same way that kayaking is dangerous to people who do not know how to swim. A successful trader will not necessarily have a bias to be ‘long only’ or ‘short only’ because one has less risk than the other. Generally, markets fall faster than they advance and shorting is a leveraged form of trading so an understanding of leverage is a must for traders who wish to go short. I would certainly urge caution when shorting. Spread bettors and CFD traders have an advantage in this regard because leverage is an integral part of their trading.

Apologies if this post has the overtones of a rant, but I hold strong views about the ability to short: it is as valid as going long. What are your views? If you disagree with any of the above, leave a comment below.

Happy trading.

The Simple Trader

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