What is short-selling?

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

A photo of high rise offices with share market graphic overlaid
Image source: Getty Images

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 us 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), you probably do 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 retail investors. But it is widely available to institutional and ‘sophisticated’ investors, and 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 see it has a high level of short-seller interest, this 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 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. 

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, 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 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 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 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 unsavoury. 

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

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.

Last updated 25 March 2022. 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.