What is short-selling?

Short-selling, or ‘shorting’, is a term you may encounter in your ASX investing journey, but what does it mean?

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Short-selling is not available to most ASX retail investors, but it’s a process worth understanding. That’s because short-selling activity can tell you much about the value the financial market places on shares and other assets. 

Looking at short position reports to see how many investors are ‘shorting’ an ASX share can be a valuable gauge of market sentiment. It may even help you decide whether buying or selling a share is the right move for your portfolio.

So, let’s take a deep dive into the concept of short-selling.

An introduction to short-selling

To understand the concept of short-selling, let us first explain what the opposite of shorting – that is, ‘going long’ — involves. Going long on an ASX share means buying the share with the expectation that its market price will rise over the long term. 

It’s the type of investing in which most of us solely participate. If you buy shares in the Commonwealth Bank of Australia (ASX: CBA), you probably do so because you think it will make a profitable investment over time. This is called ‘going long’ on Commonwealth Bank.

In contrast, when an investor ‘shorts’ a share, they hope the opposite will occur, and the price will go down over the short to medium term. That’s because an investor who short-sells a share will profit if the share price falls at the expense of the investors who are ‘long’.

Short-selling is not ordinarily available to retail investors. But it is widely available to institutional and ‘sophisticated’ investors, like hedge fund managers. Short position reports are publicly available on the ASX and are helpful for analysing a company as a potential investment. 

A high level of short-seller interest indicates a general expectation among professional investors and traders that the share price will go down. This could signify you have missed something in your research that others have not. 

How does short-selling work?

Going long on an ASX share is a concept that is relatively easy to understand. It involves buying shares on the market for a specific price and having those shares transferred to you. You now own an asset and thus will theoretically benefit if the price of that asset rises.

Shorting is a bit more complex, though.

If an investor wants to short-sell a company, they will first borrow someone else’s shares and arrange a date upon which they have to return them to the original owner. The short-seller will then sell those shares, repurchase them at the agreed-upon date and return them to their original owner.

Let’s use an example to see how this can profit a short-seller.

Say Commonwealth Bank shares are trading for $80, and a short-seller initiates a three-month short position with 100 shares. They will borrow these 100 shares and immediately sell them for $80 each, banking $8,000. 

Three months later, Commonwealth Bank shares are now trading for $50. The short-seller repurchases 100 Commonwealth Bank shares for $5,000 and returns them to the original owner, making a profit of $3,000. This is equivalent to how much the long investor has lost on paper.

Of course, this can work in the opposite direction as well. If, after three months, Commonwealth Bank shares are $100 each rather than $50, the short-seller still has to return the 100 shares but at a higher price. Thus, the shorter would be $2,000 poorer at the end of the transaction.

Because a trader uses borrowed shares when short-selling stock, shorting is a form of leveraged trading (similar to trading on margin). Investors can potentially make substantial returns with little to no initial outlay. However, if the market moves against them, it can leave them on the hook for huge amounts of money.

In a short trade, the risk is that the market price of the shares sold short will rise substantially. This might mean that the short seller is forced to buy back the borrowed shares at a much higher price than the initial loan.

What is a short squeeze?

Many investors were introduced to the idea of short-selling in 2021. This was when users of the social media website Reddit carried out a short squeeze on several meme stocks, notably those of video game retailer GameStop Corp. (NYSE: GME).

In a short squeeze, investors target a stock that the market has heavily shorted. They then start buying shares in this stock, driving up its share price. This prompts short-sellers, afraid of losing money as the stock price rises, to buy shares to cover their short positions. In other words, they buy enough to return the borrowed shares. However, this contributes to more market demand for the share, increasing its stock price even further.

Short-sellers can lose significant amounts of money in a short squeeze. The more short-sellers panic, the faster the share price rises, leaving the shorters who were slowest to react out of pocket. And, because there is no ceiling on how high a share’s price can climb, short-sellers’ losses can be (at least theoretically) limitless.

Is short-selling a good thing?

Short trading is always an area of controversy in the world of investing. Its proponents argue that by allowing short-selling, the market encourages investors to sniff out fraud, dodgy accounting, or any other illicit business activity that might go unnoticed by a long-only market. 

Indeed, some investment firms and hedge funds operate with the sole purpose of identifying these activities to profitably short-sell the companies that perpetrate them.

However, short-selling also attracts its fair share of criticism for how it allows investors to profit from a company’s distress — which some people view as immoral. When a company fails, it negatively affects its employees, customers, and possibly the broader economy. Some critics argue that having large groups of investors hoping for that outcome introduces perverse incentives into the stock market.

It can also incentivise false claims against a ‘short target’ company to create market panic among its shareholders, creating a groundless (but profitable) short-selling opportunity. For example, short-sellers have targeted ASX logistics company WiseTech Global Ltd (ASX: WTC) on multiple occasions.

Even so, short-selling looks as though it’s here to stay. Hopefully, you now have a deeper understanding of this investing practice and how it relates to you as an ASX shareholder.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended WiseTech Global. The Motley Fool Australia has positions in and has recommended WiseTech Global. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.