Short Selling – Making Money On Falling Prices

The Wirecard case has shown in recent days that other prominent examples can be found quickly and are no longer impossible to count on ten fingers. One thing is always the same in these cases – the short sellers are depicted as the bad guys. In Germany this can go so far that a ban is imposed on them. In the case of Wirecards, it took several weeks during which the short selling of Wirecard shares was prohibited. Yet it is not at all immoral and certainly not illegal to make money with falling share prices and thus profit from the failure of some. In the FAZ, the short sellers in the Wirecard case are praised for their commitment, because they had already suspected that not everything is done legally here.

In this article we want to show what a so-called short sale actually is and how it can be used to invest successfully on the stock market.

What is short selling?

Anyone who is active on the stock exchange actually hopes to profit from rising prices with their purchases. You buy a share and want to see it rise and rise and rise. The colour red is not a welcome colour for every investor. But you can also profit from it when prices fall. Then one speaks of a short sale.

Every short sale is preceded by a desire to trade. No matter what exactly you are trading, you have to place an order even in a short sale. The stock exchange does not work differently than a weekly market. Every buyer must also be faced by a seller and vice versa, otherwise there is nothing that can be traded. You are then ready to conclude the trade at a certain price. Unlike the weekly market, you do not communicate directly with the buyer or seller, the broker does this work.

The buyer then pays the called price and according to his order, a certain number of the desired shares are booked into his securities account. What exactly the seller does is not yet clear. He has either sold shares in order to take profits or minimize risks or he has made a short sale. He therefore expects falling prices and so the seller has developed a trading situation in which he will profit from this event.

How do short sales work?

In a short sale you bet on falling prices. But how is one to know whether prices will fall in the future or not? This is difficult to answer and therefore you have to be well informed about it. However, if the harbingers of some annual reports suggest that a company is currently not doing so well, this could be a good opportunity for a trade. If the share price of a promising company falls, you will find a good time to start trading. But then you have to wait until the share price has recovered and that can take some time.

The alternative is short selling. Here you bet on the falling share price and can immediately profit from the fall in the share price.

Let us make it exemplary:

You read in the newspaper that a new diesel scandal is brewing and from this you can already deduce the first profit warnings of the car manufacturers. You therefore assume that the share price of BMW, Volkswagen and Co. will fall in the near future. Because they expect massive losses at BMW, they want to bet on falling BMW share prices. Unfortunately, you have no BMW shares at all, so how do you sell something that doesn’t belong to you?

This is where short selling comes in. Your broker gives you the opportunity to sell shares that you do not own at all. So he lends you the desired number of shares. Through this process, you profit from now on when the stock goes down and keeps going down. However, every transaction also creates obligations. For example, the broker wants you to offset the negative position at a later date, because he too wants to earn something after all. That is why at a later point in time, the short sold number of shares must really be bought. This clearing of the transaction is then the second step of the short sale.

In short:

  1. step: selling shares that the broker is lending to an investor.
  2. Step: Clearing the “account” by buying the negative position.

Difference between short selling and short selling

If one deals with the trading option of short selling, then the term short selling is used again and again. This is a more international term and is therefore preferred in specialist journals. However, there is no difference between short selling and short selling. The two terms mean the same thing and the procedure is the same. It is therefore only a translation of the terms.

How do you earn money with short selling?

In order to understand how and why you can make money by short selling, you need to take a closer look at the basic mathematical idea behind it. Every ordinary online broker like Comdirect, OnVista etc. display net profits and net losses on their trading platforms. For a short sale, therefore, the normally desired ratio of purchase value to resale value is turned upside down. If you usually want to achieve a significantly higher selling value than the purchase value, short selling is based on the fact that the repurchase value is significantly lower than the selling value. The lower the share is, the better for the investment, since the profits are then all the higher.

Mathematically, the following formula can be used for this:

(selling price – buying price) x share volume – transaction costs / trading costs = profit of the investment

The individual factors have to be considered in more detail.

The short sale can then come to a positive or negative end. If you put all your key figures into the upper equation and get a positive number, then you have made a profit as a trader. If the sign is negative instead, you have made a loss and the short sale was unsuccessful. Both, whether profit or loss, can still have an effect on the respective tax burden, which is why a profit of 5,000 euros, for example, only represents a net profit and tax deductions must be taken into account. A loss transaction can be used to offset profits from the same trading category.

Short sale using an example

While in “normal” stock trading you can start quite straightforwardly and many people just get started, you have to put yourself much more into the matter when short selling. Therefore we want to use an example to make it even clearer what the above-mentioned conditions mean in practice.

Our example company is 123 Trading AG, of which we know that there has been a profit warning and it can be assumed that the price will fall. Therefore, we now want to make a short sale of 500 shares at a value of 50 euros per share.

The profit warnings have been confirmed and things are not looking good for 123 Trading AG. That is why the share price will fall from 50 euros to 30 euros. So it is a very good deal for the short seller, as he gets into the profit zone. But how high would the profit be now?

(50 Euro – 30 Euro) x 500 = 10.000 Euro

Of course, transaction costs still have to be deducted from our supposed profit of 10,000 euros. Nevertheless, this trade is already visible and gives the short seller a good profit.

But what happens if the profit warning is not confirmed and 123 Trading AG delivers a very good annual report? In this example the share price would rise sharply and instead of 50 Euros at the time of the short sale it would now be 60 Euros.

(50 Euro – 60 Euro) x 500 = – 5,000 Euro

So the loss would be immense and unfortunately the broker wants to have his fees even for loss transactions. Therefore, additional transaction costs are also incurred here.

If one looks at the negative case, one should rather refrain from short selling. These can also go into the red indefinitely and so you could lose an infinite amount of money, at least on a theoretical level. In practice, however, most brokers protect against such risks, and the legislator is also active in this area time and again.

Since short selling is also a trading strategy that beginners should try out first, many brokers also offer the possibility of a demo account, where you can practice and understand exactly such cases. This minimizes the risk of gambling real money later.

Short sales are therefore quite tempting and can bring high profits. But there is also a risk of high losses and should not be neglected.

Why can you sell short?

Actually, one would assume that short selling is not a corresponding trading pattern at all. For many years it was also rather a marginal feature of stock exchange trading. In recent years, however, with the increasing number of online brokers and their diverse offers, short selling has become more and more the focus of some traders.

And each trader creates trading scenarios for himself within which he wants to operate. If you buy a share at a supposedly “favourable” price and go long, so to speak, then you expect rising prices. With these rising prices, however, one still assumes that later on one will find a trader who is willing to buy the shares at a very high price. On a weekly market this would be difficult, but on the stock market there are always many buyers and sellers together.

A short seller simply turns the trading strategy around. When short selling, one always assumes that if prices fall, there will always be someone later who wants to sell the fallen shares to us at the then lower price.

So in the end it is also a question of trading strategy. Because short selling as a strategy promises profits and some traders have found themselves to be followers of this strategy, the question of why is no longer an issue. Because short selling and short selling have become an integral part of stock trading.

What are uncovered short selling?

As described above, in theory, in a short sale you have to borrow shares from the broker and commit yourself to close this opened trading position later by buying. However, it does not always have to be the case that the broker actually lends you the shares.

If the broker lends you the shares in a short sale, this is called a covered short sale. The broker therefore has the relevant shares in his portfolio in sufficient form and can dispose of them. In the case of a covered short sale, the trader must buy back the shares of the broker at a later point in time in any case, but you can be sure that the broker can offer you these shares in the desired amount.

In the case of an uncovered short sale, this does not go so smoothly. If you open an uncovered short position as a trader, you have to fill the gap later by buying on the stock exchange or even by buying off-exchange. This creates high risks. One not only has to bear the general risk of the share price, but also the risk that there might not be any sellers of the share at a later date. If no one sells the share or if the share is excluded from trading because of possible problems, the position cannot be closed and the loss is immense.

In Germany this uncovered short sale is prohibited for this reason.

Regulation of short selling

In Germany, short selling and short selling in normal usage is actually associated with the trading of shares and not with entire indices, commodities or similar. In theory, one could indeed shorten every single traded share. But in order to protect both brokers and traders, there are clear regulations by the state.

The highest regulatory authority in Germany is the BaFin, the Federal Financial Supervisory Authority. These can regulate the market if short selling threatens to cause significant market disruption. However, this only works for domestic shares, as the BaFin has no control over foreign companies. In the famous Wirecards case, there was a short ban for several weeks in 2019, so short selling of the company was prohibited.

In general, regulations in Germany are as follows:

  • If a company or even an individual holds more short than long positions, it is called a net short position.
  • if this net short position equals or exceeds 0.2% of the issued share capital of a company, the competent authority must be informed of this fact by the next trading day without being asked
  • If this net short selling position even exceeds 0.5% of the issued share capital, publication in the Federal Gazette is required

Incidentally, the regulations in the USA are a little more specific:

  • Shares may only be sold short if they can be bought with long positions, even using a margin
  • if the share price is above $5 and the company has been listed on the stock exchange for more than 30 days

Which shares are released for short selling?

To find out which shares are available for short selling, you can contact your broker. Here you can also find out any requirements for a short sale via the broker. Otherwise, you can also use various trading platforms such as the MetaTrader to find out whether and how.

Impact of short selling on the stock market

Let us stay with the Wirecard example. Here, the last few months and especially the period at the beginning of 2019 have clearly shown that short sellers can have a major impact on the stock market. Of course, mainly on individual companies. However, if several companies are targeted by short sellers, this can of course also have an impact on entire indices. Times of falling prices are therefore predestined for short sellers, as lucrative opportunities arise here.

Due to the fundamentally increased trading volume on the international stock exchanges, the volume of shares that can be sold short has also increased, resulting in more and more short selling.

The accusation that short sellers intervene almost manipulatively in prices and companies appears again and again. However, this cannot be generally affirmed. Short selling can have an influence on price movements and, for example, can significantly accelerate or spread downward trends, but the cause cannot be found in this. Prices usually fall as a result of other internal or external events such as poor figures or general economic stagnation. Signs and evidence that short sellers are causing a price to fall cannot be found.

As already mentioned, the FAZ praises the short sellers in the Wirecard case because they have opened the ground and their scepticism has been proven correct. They also point out the partly scandalous state of affairs in the balance sheets of some companies and also in the financial supervision in the form of BaFin. In most situations, bad news about the respective company is the trigger for falling share prices. Short sellers reinforce this effect and thus provide one or the other purifying effect with regard to company valuations. Short sellers downgrade them back to more normal levels more quickly.

Positive effects of short selling

It is therefore clear that short selling can also have positive effects on markets, which are usually forgotten but should not go unmentioned. The positive aspects are forgotten, because short selling is seen as something evil and immoral. Yet it is simply one of many ways of making money in the stock markets.

When prices fall across the board, it is preceded by a wave of selling by investors. Liquidity is withdrawn from the market because investors consider the risk to be too high. But a lack of liquidity is dangerous for a functioning market. Short sellers create new liquidity through their trading strategy and thus secure the cash flow of the trading venues.

Short sellers are also responsible for some price outbreaks and, more recently, even for some price explosions. The Robin Hood Trader from the USA has thus managed to drive broken companies to new heights on several occasions in recent weeks. If the short sellers cover themselves with short positions of a company, this can lead to a massive increase in demand for a company and the so-called short squeeze occurs. However, this is not profitable for the short seller.

Short sellers can thus cause prices to fall rapidly because they accelerate their already existing downward movements. But they also help the market and a recovery through the shorties is also conceivable.

The Short Squeeze

The term short squeeze is used again and again and is difficult for some to understand. This is due to the fact that you need to know about the specifics of short selling in order to understand what the squeeze actually is. It is the shortage of supply of a share that was previously shorted with a high volume. After short selling, these open positions must be closed sooner or later. If the price of a share now rises against the expectations of the short sellers, they must buy back the securities as quickly as possible to limit losses. This creates increased demand, which drives the share price further and can sometimes lift it to undreamt-of heights in a very short time. However, this case does not offer any positive effects for the short seller. Instead, the second calculation case occurs and the short seller incurs massive losses.

Dividends for short sellers

It would be too good to be true if, as a short seller, you were to benefit from the dividends paid out on the shorted shares. But this is not the case, because a short seller is not the owner of the shares. The system of short selling only provides for the loan of the shares. Therefore, a short seller does not receive any dividends on shorted shares.

Dividends also represent a different strategy and are a reason for many to buy various shares in more passive investing. The share screeners of Aktienfinder or AlleAktien attach great importance to this. So if short selling is not a suitable strategy for you, you might find something else.

Entry opportunity for short sellers

Especially newcomers to the stock market often want to know where the price of this or that share is heading. But some of this would be crystal ball reading, as nobody can see into the future. Chart technology helps to identify suitable opportunities, but also cannot see into the future. Short sellers can, however, prepare themselves for various scenarios and trade profitably within these with good chances.

Event 1: Missed company targets

A company always sets itself goals and sometimes these goals are not achieved. Public limited companies are obliged to publish their corporate goals and all relevant facts in quarterly reports, so it is easy to find out whether the goals have been achieved or not. Analysts use key figures such as operating income and earnings per share to estimate in advance where the company stands and where it can land.

If the figures from the quarterly report are now worse than analysts expected, investors will be disappointed and some will sell their shares. Some then open a short position. If the bad reports and investors’ sales then pile up, a downward trend is in sight and a good opportunity for short selling arises.

That’s why it’s important to keep a close eye on expectations and their fulfillment or non fulfillment

Event 2: Financial market crash and economic crisis

The economy always moves in waves and sometimes these waves can be strong up and also strong down. In the recent past, there have been repeated major crashes and thus sharp declines on the stock markets, as the financial and economic situation of the global economy had deteriorated considerably. In 2000 the dotcom bubble burst, in 2008/2009 Lehman Brothers and Co. caused a real estate bubble to burst, which then led to the financial and economic crisis. In 2020, the corona pandemic, an external effect, leads to a downturn in the markets.

All these crashes are perfect opportunities for short sellers, as a lot of money can be made in these times. However, one must bear in mind that the markets can also recover and share prices can rise again accordingly. Then short selling is no longer worthwhile and the positions should be closed.

Event 3: Corporate scandal

In the third case, we would be back to Wirecard and the corporate scandals. In recent months, however, there was not only Wirecard, but also Luckin Coffee (a kind of Chinese Starbucks) or Steinhoff. All of them for falsifying balance sheets or the accusation of doing so. But the diesel scandal at VW and other car manufacturers is also part of this.

A company scandal can be just as good for any short seller, as prices here fall rapidly and sometimes more predictably. The bigger the scandal, the worse the effects of it and the more the share price falls. So it is a good opportunity to enter the market via short selling. But here too, caution is advised. The scandal can be over faster than expected and the good opportunity becomes a risk of loss.

Risks of short selling

Where there are great opportunities, there is usually also a great risk hidden. As already described, short selling offers good opportunities to achieve high and fast returns. However, there can also be a loss. Simple mathematics has already proven this above.

The difference to normal stock trading is that with a so-called long position you cannot lose more than you have invested in it. If a company goes bankrupt and you didn’t get out in time or had set a stop loss, then the invested chapter is gone. In the case of short selling, however, considerably more money can be lost in addition to the invested chapter, as the prices can rise and thus the risk of loss is increased.

Another risk is the so-called delivery risk. A short sale is a loan transaction, which results in the obligation to buy back all borrowed shares at some point in time. If this is not possible, a large loss can follow, which goes far beyond the invested capital.

Short sale through CFDs?

If you want to avoid a delivery risk, you also have the possibility of short selling through CFDs. Because the market means and the bills are the same. Since with a CFD you only participate in the price difference, there is no obligation to deliver as with shares and therefore this risk can be excluded. If one assumes falling prices when trading, one can cover this by selling the share or the short position through a CFD.

The risk of loss is present with both types of short selling, but so is the chance of profit. Who realizes however over a CFD the short sale, often finds brokers, who limit the risk in the trade and keep the possible losses on the invested capital limited. Admiral Markets, for example, offers such a safety net.

Conclusion on short selling

Short selling is generally more of a tool or an overall trading strategy for experienced traders who know what they are doing and who already have some market experience. However, even for newcomers there may be the odd opportunity to profit from falling prices.

For some, short selling still seems to be an immoral construct, where you enrich yourself by the losses of others. Of course, a massive fall in a company’s share price can be a very good return opportunity for the short seller, while jobs are lost, for example. Moral concepts on the stock exchange should, however, in principle be negotiated by each trader with himself, in order to determine what is okay for him and what is not.

When short selling, one should definitely consider the high risks of loss and also the obligation to deliver, as otherwise it can quickly turn into a bad investment. In general, however, short selling also offers attractive opportunities, which is why opportunity and risk largely balance each other out.

If you want to sell short yourself, you should in any case approach the subject with a demo account of a broker and slowly get a feeling for it.

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