Short selling, or shorting, means selling what you do not own. When it is believed that a stock will shortly go down in value, perhaps because it is overpriced or perhaps because of a one-time event that will have a predictable effect on its market value (such as a merger,) an investor may borrow shares in that company for a relatively small fee, and sell them immediately.
Is Short Selling Unethical?
When the price drops in value as expected, the investor buys back the shares at the lower price, keeping the difference, and returns the shares to their owner.
Shorting has been criticized as unethical, as it seems to be taking profit at the expense of another’s bad fortune.
Nowadays, it is a mainstream practice and a common strategy.
Problems arise when the stock does not perform as expected, and rises in value rather than declining.
Short selling is potentially more disastrous than ordinary trading.
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If you make a normal investment and buy shares that you think will go up in value, the worst-case scenario is that the company will pull an Enron and you will lose your entire investment.
In other words, you can’t lose any more than you spent. With short selling, the potential for loss is unlimited. The shares could keep going up and up, and you will have to buy them back eventually.
Can Short Be Used As Part Of Complicated Strategies?
Short selling can be part of more complicated strategies, and can also be used to limit loss and account for otherwise-disastrous unforeseen events.
Consider a scenario wherein two companies are in the same business, but one is expected to do better than the other. Let’s say, the hedge fund manager has reason to believe that ExxonMobile will outperform Chevron. The manager would buy Exxon stock while simultaneously short-selling Chevron.
Now say that in the next election, a president is elected who is not in the pocket of big oil, and who drives through legislation requiring all cars to have hybrid technology within the next few years.
Of course, this sends the stock of both companies plummeting. Despite this, as long as Exxon does at least slightly better than Chevron, even though both stocks are going down, the manager will turn a tidy profit.
Conversely, suppose a terrorist attack blows up a key oil pipeline, sending the price of oil skyrocketing along with shares of Exxon and Chevron.
Again, as long as Exxon outperforms Chevron, the manager will profit despite the loss from the short sale. This is called a market-neutral strategy, capable of withstanding the ups and downs of a particular market.
Some hedge funds may be dedicated to short selling. Managers of these funds scrutinize financial statements for warning signs that a company’s stock is overvalued. Skilled managers may be the first to predict a company’s collapse.
However, this strategy is particularly risky. When General Motors stock was widely expected to fall in early 2005, but instead increased in value, several hedge funds specializing in short sales were forced to retire.
Perhaps the most famous short sale occurred in the British currency market on September 16, 1992, a date now known as Black Wednesday. The sale was initiated by currency speculators, most prominently among them George Soros, known ever after as “the man who broke the bank of England.” Soros’ private hedge fund, called Quantum, bet that the pound would fall in value.
The pound was being artificially propped up to conform to the European Exchange Rate Mechanism, which limited the degree to which European currencies could fluctuate relative to each other. Soros and other currency speculators saw that the pound was overpriced and that it would have to be withdrawn from the ERM – especially if they gave it a push.
They shorted large sums of pounds, trading them for strong German marks. In desperation, the government tried to tempt currency speculators to buy pounds by significantly raising interest rates, but to no avail.
The pound was withdrawn from the ERM that evening, and the currency plummeted in value. Soros made over one billion U.S. dollars in one day, a testimony to the jaw-dropping potential earning power of hedge funds.