Short-selling effectively means the selling of an asset you do not own with the objective and hope that the price of the asset declines to a level where you can buy it back and make a profit. The assets include commodities such as oil, gold and other metals, equities, government bonds and their derivative instruments, such as futures, and even the volatility of the prices of the assets. In most cases, the assets are listed on some or other exchange. Short-selling can take many forms, and the reasons for selling an asset not owned by an individual or company may differ vastly.
Speculators - more commonly known as market traders - follow scalping strategies that involve the making of a large number of intraday trades that produce small profits individually and also involve the selling of assets that they do not own.
Some traders use indicators that point to the price of an asset about to lose upward momentum - popularly referred to as “overbought” - and they then sell the asset with the aim of buying it back at some stage, either when they think they have made enough money or when their indicators point to the price decline losing momentum. When the speculator’s main activity is to look for opportunities of potential price declines, he is aptly called a short-seller.
Short-selling is also used for arbitrage purposes, where the aim of the investor or market trader is to make a riskless profit from unjustified price differences, such as when the asset or instrument of the asset, such as a futures contract, trades out of line with the underlying price of the asset. They normally unwind the position when the prices get in line again.
Another popular arbitrage and example of short-selling is when a market participant takes a view that a stock’s valuation is completely out of line with its peer group or another share in the same type of business, or even the market as a whole. In this case, the share is shorted, and depending on his preference, the participant buys the other share or the market.
Short-selling is used extensively for purposes of hedging or reducing risk. In the case of a fund, individual or financial institution, the participant may feel uncomfortable with the level of the market as a whole, but instead of selling the holdings in his portfolio, he sells the market by selling the listed futures on the particular market and thereby reduces his market risk.
Short-selling is also used to reduce specific risk. If a financial institution has significant exposure to a specific company’s debt - whether the debt or bond is listed or not - and the particular institution gets worried about the company for whatever reason and is unable to offload the debt or bond because of illiquidity, it makes sense to short the shares of the company. Yes, selling shares not owned by the financial institution to reduce the risk of failure of the company in question.
But how can you sell something that you do not own? How can you deliver the asset to the buyer? It is easy: you borrow the asset from somebody else. In the case of securities, lending the transactions involves the owner of shares or bonds transferring the assets temporarily to a borrower to meet the temporary needs of the borrower.
In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee to the lender. The borrower agrees to return the identical shares or bonds to the lender some stage in the future, while the collateral assets are returned to the borrower.
It is virtually impossible for the ordinary investor or fund manager to observe the share-lending activities, though. Ordinary investors and even fund managers can be caught totally unawares if a share price suddenly starts to fall as a result of some of the borrowed stock entering the market.
While short-selling and the lending of securities in normal circumstances are quite healthy for the financial markets, it opens the way for abuse. It is especially relevant in regard to insider trading and market manipulation. Short positions can be built long before a major negative announcement about a company is made, and worst of it all, well-managed but relatively highly geared companies - those with high debt - may suddenly discover that their credit lines and customer base dry up, resulting in an implosion of the company and its share price.
Ryk de Klerk was co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.
The views expressed in this article are not necessarily those of the Independent Group.
- BUSINESS REPORT