The financial markets term “going short” means something very different to the household idea of being short of cash.
In markets, going short – or short selling – is the practice of selling something that is not actually owned, in the expectation of buying it back at a lower price. Going short is relatively common among professional investors, so it can be a good idea to understand how it works and the associated risks.
"Going short" is the opposite of "going long"
Going short is the opposite of the more conventional investment strategy of buying an asset such as a share, a bond or property in the hope that its price will rise – known as "going long". Short selling is a technique investors use to bet that the price of an asset will drop, allowing them to make a profit in a falling market. A share investor who has gone short can make a profit if the share price falls because they buy the shares in the future at a lower price. The difference between the lower price at which shares are bought the higher price at which they are sold constitutes a profit.
It is not only shares but also other financial instruments (such as bonds, currencies and commodities) that can be shorted. The eZonomics story What is ... a hedge fund? tells how hedge funds often use short investments when they believe an asset price will fall.
Short work, tall profits
During the recent global financial crisis some institutional investors made profits from betting that prices of assets would fall. One of the most famous examples is of John Paulson, a United States hedge fund manager who, writes The Daily Telegraph, made a personal profit of $3.7 billion (€2.5 billion) by short selling to bet that the prices of assets based on property prices would fall.
In early 2011, a fund managed by PIMCO, the world's largest bond trader, shifted to a short position in US government-related debt. The move suggests the fund manager thought the interest rates on US government bonds were low and would eventually increase. An increase in interest rates would reduce the price of bonds and make the short position profitable.
In the world of cinema, the 1983 fictional film Trading Places tells of profit making through the short selling of frozen, concentrated orange juice futures.
Long and short of it
Going short is not all about speculative investing. Investors can use short selling to protect their "long" positions on certain assets. Investors with large long positions that they cannot quickly reduce can use short selling of similar assets to hedge against a temporary fall in the prices of those assets. For example, farmers might go short on wheat price futures to hedge against the risk that the price of their harvests falls before they sell their goods.
Not a one-way bet
Like all financial transactions, short selling has risks but the risks involved in short selling can be particularly large and difficult to manage. Investors who go short can face large losses if prices rise rather than fall. An investor who went short on an asset worth €100 would lose €900 if it rose to €1,000. In contrast investors who take long positions by buying a share can only lose the money they invested if the price falls. Those who want to go short must organise this through a broker or an exchange. They usually pay a fee each day for borrowing the stock from the person who owns it. The fees associated with short positions can add up quickly.
As a result, shorting can be very expensive and the cash flow can be difficult to manage.
It is typically used only by experienced investors.
Short sellers have often been blamed for exacerbating price falls at times of financial turmoil. Criticism of short selling was expressed as long ago as the Dutch tulip fever of the 1600s and the Wall Street crash of 1929. During the most recent financial crisis, regulators in several countries restricted the use of various forms of short selling.
Critics of short selling say the practice can add to market turmoil and cause disorderly trading. Advocates of short selling say that it makes markets more efficient, allowing the true price of assets to be found more quickly than if it were not allowed. Researchers at Duke University in the US found that short sellers exploited markets' misconceptions about a share's value. International regulator IOSCO said in 2009 short sellers should be made subject to a compliance system and a reporting regime but not banned outright.
Clarity Economics’ lead consultant