What is Short Selling?

Short selling is a term you may come across in the course of your ASX investing journey, but what does it mean?

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Short selling (sometimes condensed to ‘shorting’) is a term you may come across in the course of your ASX investing journey.

While short selling is not available to most ASX retail investors, it’s still a process worth understanding. That’s because short selling activity can often move the share market substantially. 

Looking at how many investors are ‘shorting’ an ASX share can also be a valuable gauge of market sentiment and may 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.

What is short selling?

To understand the concept of short selling, let me first explain what the opposite of shorting – that is, going long – involves. Going long on an ASX share means buying a company with the hope and expectation that its share 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), for example, you are probably doing so because you think it will make a profitable investment. 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 investors who are ‘long’.

Short selling is not normally available to ordinary retail investors. But it is widely available for institutional and ‘sophisticated’ investors as well as fund managers. Short seller information is publicly available on the ASX and is a helpful tool for analysing a company as a potential investment. If you are considering a company for an investment, and you see it has a high level of short seller interest, it could signify you have missed something that other investors haven’t. 

How does short selling work?

Going long on an ASX share is a concept that is relatively easy to understand. It involves buying a share for a price upon which the ownership of said share transfers 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 will be returned 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 owners.

Let’s see how this can profit a short seller with an example.

Say Commonwealth Bank shares are trading for $80, and a short seller initiates a 3-month short position with 100 shares. They will borrow these 100 shares and immediately sell them for $80 each, banking $8,000. 

Fast forward 3 months, and 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, in the process making a profit of $3,000, which 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 the 3 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 than they initially sold them. Thus, the ‘shorter’ would be $2,000 poorer at the end of the transaction.

Is short selling a good thing?

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

Indeed, there are investment firms that operate with the sole purpose of finding these sorts of 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 unsavoury. 

It can also incentivise false claims against a ‘short target’ company to create market panic amongst a company’s owners, thereby creating a groundless (but profitable) short selling opportunity. 

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

Last updated 11 August 2021. 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 no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.