Share Trading. What is Short Selling?

Australia's ban on short-selling of financial stocks on ASX ended on Monday. What is short selling? Why did ASIC ban ASX short selling?

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Short Selling Short Selling

What is Short Selling?

The Australian Securities and Investments Commission (ASIC) banned short-selling last September when the collapse of Lehman Brothers sparked extreme market volatility and wild rumours about other possible corporate failures.

Short selling is a term that is very commonly used in the trading of shares. Now that the short selling ban is lifted, it is important for investors to have a good understanding of the meaning of short selling.

Short selling is when a trader borrows a share and sells it in the hope of buying it back at a lower price. Because the trader benefits if a company’s share price falls, short-selling has been linked to false, negative rumours about companies — rumours intended to push share prices down.

ASIC said in March, when it last extended the ban on financial stocks, that it had “weighed up” global market volatility, and potential predatory behaviour by short-sellers, against the “possible loss of some market efficiency or price discovery”.

Stocks represent a small piece of ownership of a company that is bought by an investor through a broker in order to make profit of it. There are times when an investor anticipates that a stock will increase in value and makes a deal in order to gain in the long term. This is when the investor “goes long on an investment.” Conversely, when an investor thinks that there will be a decrease in the share price in future, he/she “goes short on the investment.”

Short selling or “shorting” is a practice of selling securities that the investor does not own it at the time of sale. The investor anticipates that the price of the stock will decline in the future and short sells it in order to purchase the security at a lower price. A short seller “borrows” the securities to be sold and repurchase them for returning to the lender. If the price of the stock declines, the investor can make huge profits by short selling them. Conversely, if the price rises the investor can lose a huge amount of money.

Short Selling – An Example

For example, a company AB currently has a value per share of $5. A short seller now borrows 100 of these shares from the broker and sells them at $500. Later when the price of the share declines to $3 per share, the investor buys the 100 back for $300 and makes a $200 profit (borrowing fees deducted from this). Conversely, if the price rises to $10 per share, the investor can lose $500.

For short selling, an investor needs to open a margin account with the broker. This allows the investor to borrow from the brokerage firm using the value of the portfolio as collateral. In general, the value of the portfolio must be at least 50% of the size of the short sale amount. For a short sale, an investor needs to instruct the broker. The broker can only borrow a stock if the particular stock is allowed to be borrowed. Similarly, it can be bought back when the price declines. The profit then goes to the margin account of the investor.

An investor short sells due to two prime reasons — opportunism and portfolio protection. Sometimes an investor might feel that a particular stock is tremendously overpriced and is bound to fall. Short selling allows him/her to profit form that fall of price. Also, it helps investors insulate their stocks at the time of an economic downturn when prices of all stocks are bound to decline. It is also seen by some investors as a way to diversify a long portfolio by short selling some stocks. This can reduce the volatility in the portfolio as a result of an economic downturn and helps to profit even when the prices of stocks are falling.

However, short selling involves many risks as the mechanism here is much more complicated than a normal stock market transaction. There is high risk involved along with a potential to earn huge profits. Therefore, an investor must be fully aware of the mechanism and the risks involved before he/she attempts to short sell any security.

(Source: The Age and Ezine Articles)

More info: SOGO –  www.sogotrade.com ASX – www.asx.com.au

You may also like to see our reviews of ComSec share trading, E*TradeBell DirectStock Market Report.

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The review "Share Trading. What is Short Selling?" was last updated on 27/05/2009.