O short selling or, in Portuguese, short sale, consists of sell a financial asset, such as shares, that you do not own. In other words, in practice, it is a way of earning money with fall of a certain asset.
Normally, this type of operation is carried out by traders experienced professionals or investors.
O short selling is used for the purposes of pure speculation, betting only on the price of a security falling. Alternatively, it can work as a way to protect the investor in times of market turmoil.
As you will see below, it is an operation that involves a great risk and as such, not suitable for people with little experience in the financial markets.
How does the short selling?
As mentioned above, the short selling it is a way for an investor to make money from the fall in the value of a stock. O short selling works as follows:
- The broker where the investor has an open account lends a certain financial asset to the investor;
- the investor sell this asset at a certain price;
- The position result short (short position in Portuguese) varies according to the asset price. If the price drops, the investor makes money. On the contrary, if the price increases, the investor loses money. It should also be noted that for each day that the investor maintains the position short, the broker charges a daily swear due to the fact that it lent an asset to the investor;
- To close the position, the investor must buy this asset on the marketand the result of the operation is dependent on the price variation.
To understand, in practical terms, how the short selling, nothing better than a practical example. Let’s consider the following situation:
- opening a position short in shares in Galp, with the sale of 100 shares at a price of 10 euros per share;
- The investor holds the position short for 1 month;
- position closing shortwith Galp shares worth 9 euros per share;
- Interest charged by the broker of 1% for one month.
In this case, when initially selling 100 Galp shares for 10 euros each, the investor obtained a total of 1,000 euros. Then, at the end of a month, the investor decided to close the position by returning the 100 shares to the broker. To deliver them, the investor had to buy 100 shares of Galp, having spent a total of €900.
In short, the investor received 1,000 euros and, later, only had to spend 900 euros, to return the same 100 shares that the broker had lent him. In the end, with this operation, the investor earned 100 eurps.
Finally, the interest charged by the brokerage firm must be deducted from these 100 euros of profit. Being 1%, this means that the broker charged 10 euros in interest, equivalent to 1% of the 1,000 euros initially received. In short, the total profit from this operation was 90 euros.
risks of short selling
O short selling, as mentioned above, this is a very risky operation. The main risk associated with short selling is the fact that the losses are potentially unlimitedwhich does not happen in the case of acquisition of shares, in which the maximum risk of loss is the entire capital invested.
PFor example, if the price of a share triples during the time the investor holds a position shortthe loss will be 3 times the value of the position short. Ie, a position was opened short of 1,000 euros, ends up losing 3,000 euros.
In short, it is a very risky operation, and normally only recommended for short periods of time.
The usefulness of short selling to the market
O short selling is involved in great controversy. For many, it is an unethical type of movement that should not exist.
However, those who carry out short ends up bringing some efficiency to the market. This is because, if the shorts are carried out in overvalued shares, they generate a fall in the price, causing other investors to stop paying such a high price.
What are the ideal conditions to open a position short
Although it is a very risky operation, there are some specific situations in which there can be interesting gains with this type of operation. Some of them are highlighted below:
- market in bear market: this period, in which there is widespread pessimism throughout the market, is a good opportunity to make money from the short selling. Situations such as the 2008 financial crisis and Covid-19, in 2020, turned out to be examples of moments when shorts they had their success;
- Weak fundamental indicators: stocks with declining fundamentals are often interesting targets for short sellers. That is, companies with negative prospects for sales and profits, or with a precarious financial situation. This is because they are stocks where there are great prospects for their value to fall;
- Stocks with very high valuations: stocks that are clearly overvalued also tend to be victims of short selling. This is because their evaluation often presupposes certain results that, in many cases, end up not being confirmed. Thus, they are stocks where there can be a good margin of gains with the short selling.
The concept of short squeeze
O short squeeze is a concept closely linked to the short selling.
O short squeeze happens when there is a sharp rise in the price of a particular stockwhich leads to a strangulation of those who have open positions short. Thus, these investors are forced to close their positions to avoid further losses, which further fuels the rise in stock prices.
As a rule, a movement short squeeze is usually more common in stocks that have a high number of positions short opened.
To assess the weight of positions shortthere is a relevant indicator called Short Interest Ratio. This indicator measures the weight of the number of shares shorted in relation to the total number of shares outstanding in the market. The higher this indicator, the greater the probability of an event of short squeeze.
The biggest short squeeze of history happened in 2008 with the shares of Volkswagen. With the serious financial crisis that befell the world that year, with the company’s high debt, and the difficulties of the sector, Volkswagen was looked at with great interest by investors. short.
Interestingly, the short interest ratio nor was it very high at the end of 2008, being around 12.8%.
However, everything came to a head with the announcement that Porsche had acquired around 74% of the company’s shares. In view of this, the number of shares available to the shorts close their positions was greatly reduced, which generated a total panic among these investors.
In short, this panic caused the value per share to increase 5 times in just two days. It is estimated that investment funds with positions short have lost about 30 billion dollars. In contrast, Porsche was a big winner of this situation, estimated to have raised about 10 billion dollars with the operation, which, at the time, was quite useful to ensure its survival.
In short, the short selling can be an attractive type of operation in times of crisis in the markets. However, given its high risks, it is not at all recommended for unskilled investors with little experience in the financial markets.