SHORT SELLING

By Daryl Guppy

Short selling changes the order of buying and  selling. It means you sell FIRST and buy SECOND. If you sell at $1.00 and buy at $0.50 you have a profit. Its  no different from buying at $0.50 and selling at $1.00 except the order of buying and selling is reversed. There are four  types of short selling

CONTRA TRADING

This relies of trade settlement inefficiency. In markets where the settlement period is T+3 it means the trader has 3 days to pay after the original trade is made. He can buy on Monday and pay for the shares before the close of trading on Wednesday. In short-side trading he SELLS the shares on Monday and BUYS them again on Wednesday, hopefully at a profit. As long as the trade is settled within the T+3 trading rules there is not a problem. This is a simple shorting method used by retail traders.

 COVERED SHORTS

The trader borrows shares from a stock lender. He then SELLS  these on the market. He pays the stock lender a borrowing fee, calculated daily. When the trader thinks the downtrend is ending, he BUYS the shares back, and returns them to the stock lender. This method is used by institutions and fund managers and the market makers for some derivative products. It has limited use by retail traders.

 NAKED SHORTS

The trader simply SELLS shares he does not own, and has not physically borrowed. He may enter into an agreement with his broker to pay a ‘carry’ cost while the trade is open. This may be a private arrangement, or done more formally using a traded put option or put warrant. This is a financial arrangement between the trader and an intermediary. When the trader BUYS to close the position he simply transfers cash as a settlement for the trade. This is believed to be a significant area of activity used by some hedge funds.

Technically an option or warrant trade carries an implied  ownership of the underlying shares, but this is a naked short trade because the stock has not been physically borrowed by the trader. The trade has  aright, but not an obligation. The instrument may be converted to shares, but are usually closed for cash settlement prior to the expiry date of the instrument.   These instruments are an important method for risk management for retail traders.

DERIVATIVE SHORTS  

These are financial instruments that confer no ownership of the underlying shares. The CFD (Contract for Difference) is the best known in the retail market. Futures Index trading is also a pure derivative instrument. Trade settlement is in cash, not in shares. The direction of the underlying Index determines the profit or loss on the trade. The derivative follows the price activity of the underlying, but does not influence the underlying. Derivative shorts are used by funds and retail traders.

HEDGING

Hedging strategies, and hedge funds use a combination of long and short trading strategies and derivative instruments to manage risk. The objective is to offset the impact of falling prices  on the overall portfolio performance. Generally hedging uses derivatives rather than covered or naked shorting.