Generally, the two main reasons to short are to either speculate or to hedge.
When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high-risk investment. Speculation has been perceived negatively because it has been likened to gambling. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it. (For more insight, see What is the difference between hedging and speculation?)
Speculators can assume a high loss if they use the wrong strategies at the wrong time, but they can also see high rewards. Probably the most famous example of this was when George Soros “broke the Bank of England” in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion.(For more on this trade, see The Greatest Currency Trades Ever Made.)
Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.
For reasons we’ll discuss later, very few sophisticated money managers short as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.
Hedging can be a benefit because you’re insuring your stock against risk, but it can also be expensive and a basis risk can occur. (To learn more about hedging, read A Beginner’s Guide To Hedging.)
Many restrictions have been placed on the size, price and types of stocks traders are able to short sell. For example, penny stocks cannot be sold short, and most short sales need to be done in round lots. The Securities Exchange Commission (SEC) has these restrictions in place to prevent the manipulation of stock prices.
As of January 2005, short sellers were also required to comply with the rules set in place by “Regulation SHO“, which modernized the rules overseeing short selling and aimed to provide safeguards against “naked short selling.” For instance, sellers had needed to show that they could locate and get the securities they intended to short. The regulation also created a list of securities showing a high level of persistent sales to deliver.
In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines. The rule has been around since the creation of the SEC in 1934. One of the reasons it was put in place was to slow rapid and sudden declines in share prices that can occur as a result of short selling.
In July of 2008, the SEC used its emergency powers to put an end to market manipulations, such as spreading negative rumors about a company’s performance and sharp price declines. The markets had been volatile as a result of the of mortgage and credit crisis, and the SEC wanted to establish a renewed confidence. For a month, it didn’t allow naked short selling on the stocks of 19 major investment and commercial banks, which included the mortgage finance companies Fannie Mae and Freddie Mac. (To learn more, read The Uptick Rule: Does It Keep Bear Markets Ticking?)
The SEC took further measures in September of 2008, once again using its emergency authority to issue six orders to minimize abuses. This included a move to halt short selling in shares of 799 companies in cooperation with the United Kingdom’s Financial Service Authority. 170 companies were later included in the ban, which ended after the passage of the $700 billion U.S. bailout plan in October 2008. Another order required short sellers get a sale and immediately close it by making sure the shares were delivered. It later became a rule.
Some insiders indicate that it takes a certain type of person to short stocks.
Many short sellers have been depicted as pessimists who are rooting for a company’s failure, but they’ve also been described as disciplined and confident in their judgment. (To learn more, readQuestioning The Virtue Of A Short Sale.)
Sellers are typically:
- wealthy sophisticated investors
- hedge funds
- large institutions
- day traders
Short selling isn’t for everyone. It involves a great amount of time and dedication. Short sellers need to be informed, skilled and experienced investors in order to succeed.
They must know:
- how securities markets work
- trading techniques and strategies
- market trends
- the firm’s business operations