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What is short-selling?

Each week, fellow contributor James Mickleboro publishes a list of the most shorted shares on the ASX. Since this metric is so widely followed in the media and among investors, I thought it could be useful to explain for beginners what short-selling is.

What it is

Short selling is effectively a bet against a company’s share price. Being short, or shorting, is the opposite of being ‘long’, which is buying and holding shares with a view to profiting from dividends or a rising share price.

Short sellers have had a number of coups in Australia recently, including Slater & Gordon Limited (ASX: SGH) and Quintis Ltd (ASX: QIN) which both fell more than 80% after being targeted.

Typically, a short seller ‘borrows’ shares from a large investment fund, and pays the fund a % of the value of the shares borrowed per year. Many large funds are mandated to hold certain companies regardless of their performance, so loaning shares to short sellers can be an attractive way to earn additional returns. Not all funds permit their shares to be loaned for short selling.

Having borrowed shares, the shorter then sells them, in the hopes of being able to buy them back at a lower price and return them to the lender, keeping the difference.

How it works

Just say that our fictional short-seller borrows 100 shares of Flight Centre Travel Group Ltd (ASX: FLT). They sell the 100 shares at $43, receiving $4,300.

In a perfect world (for the short seller), Flight Centre shares subsequently decline to $6. The short seller buys back the 100 shares for only $600, and returns the shares to the fund they borrowed them from. They keep the $3,700 difference (before fees) for themselves.

However, if the opposite happened, and Flight Centre shares rose to $60, the short seller would be in trouble, as they could theoretically have to buy back 100 shares at $60 each, $6,000 in total, losing $1,700.

Alternatively, if they don’t wish to buy the shares back yet – maybe they think the price will still fall – they must make sure they have cash available to cover the rise in share prices.

Sometimes, if the shorted company has a very low volume of traded shares, it can be hard for the short seller to buy back their position, resulting in them paying a much higher price than the last traded price.  This is known as a ‘short squeeze’.

Shorting is a high-risk strategy because the maximum profit is fixed; shares can only ever fall to $0. A 100% loss for ordinary shareholders is a 100% gain for the short seller who will, at best, only ever double their money.

On the other hand, the maximum amount a short-seller can lose is close to infinite – share prices can rise to 3, 4, 5 or more times their original value.

So why short-sell?

Among the Australian short-sellers whose work I have read, shorting appears to occur for two primary reasons; either a belief there is fraud or that the market is grossly wrong about a company’s valuation. Here are some of the better known shorts in recent times:

  • Slater & Gordon Limited (ASX: SGH) was short-sold because the company over-extended itself financially at the same time as its earnings were being inflated by paper movements in Work-In-Progress; its cash earnings were very low
  • Quintis Ltd (ASX: QIN) was short-sold because of several issues regarding its sales contracts and funding position; one major short seller asserted that the company was effectively a Ponzi scheme
  • Vocus Group Ltd (ASX: VOC) was short-sold because of a combination of high valuation, high debt, and the suspicion that the company would have problems integrating its recent acquisitions

That’s not to say that you should worry about short sellers. More than 400 companies currently have at least some of their shares held for short sale, according to ASIC. Not all of those will fall, and it’s also important to remember that short sellers profit by spreading fear and undermining investor confidence in a company’s shares.

However, given the high risks of shorting, in my view it is worthwhile reading ‘short’ arguments against companies you hold.

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Motley Fool contributor Sean O'Neill owns shares of Flight Centre Travel Group Limited. The Motley Fool Australia owns shares of Flight Centre Travel Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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