How to short a share
Shorting or short selling are terms that analysts and financial media have bandied about in recent months. Since we’re not in the business of selling our readers short, the Financial Mail explains what shorting is and how to do it.
Short selling enables you to benefit from the view that a share is overvalued by selling (shorting) the share and buying it back at a lower price, says Nilan Morar, head of the trading desk at GT Private Broking.
So rather than "going long" (betting that a share price will rise over time), you "go short", betting that it will fall.
To do this on the JSE, fund managers borrow the scrip (the shares) from a bank or stockbroker, immediately sell these shares into the market and then buy them back in future at a lower price, returning them to the lender and profiting off the difference.
Banks or stockbrokers source shares from within their own walls, or from pension funds or exchange traded funds.
"Banks might have shares on their balance sheets to hedge debt exposures to corporates," says Jean Pierre Verster, a portfolio manager at Fairtree Capital. "Alternatively, the bank’s retail stockbroking division might have permission from some of its clients to lend out their shares, usually with some benefit to the client, such as lower fees."
Retail investors, on the other hand, use derivative instruments known as contracts for difference (CFDs). Here, the CFD provider would source the scrip for the short seller.
When trading CFDs, you are speculating on a price movement, explains Shaun Murison, an analyst at IG, one of the world’s largest online trading providers.
Short sellers, retail and institutional alike, need to put down a deposit, known as a margin, relative to the size of the short position they would like to take.
"The margins on different stocks will vary depending on the risk, liquidity and market capitalisation," says Murison.
The margin is a percentage of the notional exposure, which is calculated by the number of shares being shorted multiplied by the price of the share, says Morar.
Say a short seller puts down a R100 deposit to gain exposure to R1,000 worth of shares (that is, a 10% margin requirement) at a price of R50/share. If the share price then moves to R60, the short seller will need to increase her margin by R20 to maintain her short position and fund the loss of R10/share.
Most CFD providers require that traders maintain the deposit amount on open trades and cover any losses they might be incurring. "It is important to bear in mind that because CFDs are leveraged instruments, profits and losses are magnified," says Murison.
A "short squeeze" occurs when a large number of short sellers are trying to exit their positions simultaneously, which can lead to a rapid increase in the share price. This is often triggered by a recall, where the party that loaned the scrip initially, such as a long-only fund manager, sells out of its position and calls on the scrip from the CFD provider, bank or stockbroker.
"If the CFD provider cannot source replacement scrip to deliver to the initial lender, the retail investor might be forced to buy the shares back," Morar explains. "Large, liquid stocks pose a lower risk of recall."
Naked shorting, where a trader sells shares she has not yet borrowed, is banned in SA. Naked shorting is theoretically possible because the JSE’s T+3 settlement cycle means trades only need to be settled three days after they are executed — that is, a seller only needs to come up with the shares and a buyer with the cash three days after making a trade.
"Naked shorting can artificially drive down share prices because the short seller can sell an unlimited number of shares," says Verster. This is so because, as explained earlier, the naked short seller would not be required to put down any margin or maintain that margin if the share price moved against her.