Can you tell us the purpose of short-selling, the risks involved and how to go about it?
An investor who has a bad feeling about a stock can
sell it if he owns it and can even sell it if he doesn't. In the latter case,
he hopes that the price will fall, so that he can buy it back, restore it to
its owner and pocket the difference.
Short-selling is not the only way to speculate that a stock will fall. Buying or selling calls are two other ways, and are often overlooked. Short-selling is done not just by speculators, but also for arbitrage and hedging transactions.
Short-sellers must first borrow shares on an over-the-counter securities lending market.
Stocks are lent via intermediaries, such as specialised teams within financial institutions, who generally borrow the shares from custody services whose clients (e.g. insurance companies, collective investment organisations and pension funds) have authorised them to do so. Owners of shares lend them out in order to enhance their performance (25 to 50bp remuneration for liquid shares, but the rate can be much higher; France Télécom recently carried a 14% rate during its capital increase subscription period), secure in the knowledge that they can recover them at any time.
The lending contract most often requires a guarantee from the borrower in the form of cash or shares. The amount of the guarantee is negotiated on a case-by-case basis and is often close to 100% of the shares' value.
The short-seller later buys back the shares on the market in order to restore them to the lender, thus unwinding the transaction and its corollary, the securities loan.
Why do it?
Short-selling is a tool commonly used by financial
market intermediaries as a medium for their business. Short-selling increases
market liquidity and efficiency, sometimes helping to regulate prices, in particular
in the case of shares that look overvalued.
Short-selling allows investors to realise capital gains, even on falling markets, but also to protect their portfolio by hedging against a market correction on the shorted stock, as well as other stocks in their portfolio (this is called an imperfect hedge).
Short-selling allows investors to use leverage to avail themselves of more opportunities for investment and gain (leverage also comes into play in bullish strategies, using the French SRD system, calls and warrants).
The risks involved
The sky is the limit on short-selling. Those who are
long on a stock (i.e. who have bought the stock) risk only 100% of their investment,
no more. Short-sellers' risk is unlimited since the upside potential of share
prices is, theoretically, unlimited.
In practice, sudden rises on a reasonably liquid stock are limited to a maximum of about 10 to 15%. However, a short-seller's loss can be substantial if the stock rises significantly before he is able to buy back the shares needed to cover his short position. The risk is greater on volatile markets, or when volumes are high on a volatile stock, as the heavier the demand, the more difficult it is to buy stocks - massive amounts of short-sellers could choose this very moment to cover their positions, which would send the share price up more sharply; this is the famous short squeeze. This is also likely to increase the stock's short-term volatility.
Investors having short positions on a stock could be tempted to manipulate the price by spreading false rumours or by using the bear raid technique in order to send the price down. Such manoeuvres (which are also seen on the upside) are punishable by law.
One more thing: short-selling carries delivery risk, when the short-sellers cannot restore the shares they have borrowed. The intermediary is particularly exposed to this risk, if he has not demanded a guarantee, such as cash or shares, but also if the guarantees it does have end up being insufficient, because of share price movements.