Short Selling

Short selling is borrowing shares, selling them on the market, and buying them back later - hopefully cheaper - to return to the lender. The profit is the difference minus the borrowing costs and any dividends the lender would have collected. The strategy bets on a fall, which inverts the normal arithmetic of investing. The maximum gain is 100 percent, when the price falls to zero, and the maximum loss is unlimited - a share price has no ceiling.

The Australian version is heavily regulated. Naked short selling - selling shares that were never borrowed - has been prohibited since the global financial crisis. Covered short selling is legal with disclosure: ASIC publishes daily short position reports showing the gross and net short positions in every ASX-listed stock. The reports are public, they are free, and they are the only window into who is betting against a company you own.

Walk one short. You borrow 100 shares trading at $50, sell them for $5,000, and owe the lender 100 shares plus fees. The price falls to $40, you buy 100 shares back for $4,000, return them, and the $1,000 difference is the profit - roughly 20 percent on the position, before the lending costs. The same trade inverted is the risk: the price rises to $65, buying back costs $6,500, and the $1,500 loss is 30 percent - with the loss climbing for every further dollar the share rises. The stop loss calculator prices the exit arithmetic.

The costs are the second mechanism. Stock lending runs at a rate - say 6 percent a year on the value of the position - and the fees accrue for as long as the short stays open. Any dividend the company pays during the short is owed to the lender, which is why heavily shorted stocks that announce dividends see the shorts cover. The position also needs margin: the lender demands collateral, and a rising price demands more of it.

The disclosure is the third mechanism, and the Australian one. Since the GFC ban on naked shorting, covered shorts are reported to ASIC daily, and the aggregated positions are published per stock. A company with 10 percent of its register sold short is a stock the market is actively betting against - information, free of charge, about where the pessimists are standing. The bear market entry covers the falls the pessimists are sometimes right about.

For an Australian holder, short selling is mostly something other people do to your stocks - and the ASIC reports tell you how much. A heavily shorted stock is not automatically a bad business. It is a stock with a priced and published bear case, and the squeeze when the bear case breaks is violent. MoneySmart treats short selling as a high-risk strategy for experienced investors, and the margin mechanics are the reason: the position demands collateral and the losses compound upward. The margin lending entry covers the collateral mechanics.

A colleague named Brent (yes, that Brent) shorted a 'doomed' retailer at $3 because the thread said it was going to zero. The retailer doubled to $6, the margin call arrived on a Tuesday, and Brent's 100 percent theoretical gain turned into a realised loss he covered from savings. The highest-leverage thing most Australians can do is read the ASIC short position reports on anything they own. Leave the shorting itself to people with unlimited loss tolerance and a better sleep schedule.