Short Selling Explained: Purpose, Advantages, Disadvantages, and Risks

Short selling is an investment technique where an investor places a sell order for a stock that they do not yet own, with the intention of buying it back later at a lower price. This strategy is typically employed when an investor anticipates a decline in the stock's price. Through short selling orders, investors can potentially profit from a decrease in the stock's value. However, if the stock price rises instead, the investor will incur a loss.

1. What is the purpose of short selling?

The objective of short selling is to enter into a transaction based on the expectation that the stock price will fall below its current price at a later point. After selling the stock, the investor subsequently borrows and returns the stock to fulfill the sell order, resulting in a profit. This is one of the ways to potentially generate profits in a bearish market.

For example, let's say person A anticipates a decline in the price of stock (a), currently priced at 10,000 won. Person A borrows stock (a) from person B and sells it for 10,000 won. A week later, the price of stock (a) drops to 5,000 won. Person A then repurchases the stock for 5,000 won and returns it to person B. In this scenario, person A has effectively made a profit of 5,000 won (selling at 10,000 won and buying back at 5,000 won). This process of borrowing a stock that you don't own, selling it, and buying it back later to return it... this is the basic concept of short selling.

So, does short selling always guarantee profit?

Stock prices can fluctuate, going up or down. While you can make a profit if the stock price decreases as anticipated, you will face losses if it rises. What if the stock you sold for 10,000 won after borrowing it increases to 15,000 won? It's not just a simple 5,000 won loss; it could be even more significant when including fees. Some might think, 'Well, can't I just wait until the price goes down?' While this is a valid thought, similar to borrowing money, when you borrow stocks, there's a set timeframe. If you fail to return the stock within that period, penalties such as interest charges might apply.

2. What is the difference between short selling and naked short selling?

Naked short selling refers to the act of placing a short sell order without having already borrowed the stock. This practice is typically prohibited or heavily regulated due to its potential to disrupt market stability. Most countries have outlawed naked short selling. In contrast, covered short selling involves borrowing the stock first, selling it, and then repurchasing it later to return it.

3. What is the relationship between short selling and the stock market?

Short selling is one of the various investment strategies employed within the stock market. The stock market offers numerous opportunities for investors, and short selling serves as a tool for investors who anticipate a decline in stock prices to potentially profit from that expectation.

4. What are the advantages and disadvantages of short selling?

(1) Advantages of Short Selling

● Enhanced Market Efficiency

Stock prices are determined by the balance between buying and selling pressures. By allowing short selling, opinions from investors who believe the stock price will rise and those who believe it will fall are reflected in the market more quickly. This contributes to increased efficiency in the stock market.

● Increased Market Liquidity

When short selling is available, it's easier to reflect selling pressure, leading to easier trade execution. This contributes to increased liquidity in the stock market.

● Improved Price Continuity

Through short selling, trading frequency increases and information is reflected more rapidly, resulting in improved price continuity where stock prices change gradually.

● Highlighting Negative Management Practices

Short selling can expose negative management practices of a company, leading to potential disadvantages like lower stock prices and stricter loan terms. This can hold company executives accountable for their actions. This contributes to increased corporate transparency and encourages sound management practices.

● Assists with Hedging

Short selling enables investors to potentially profit even in a bearish market, allowing them to manage their portfolio's returns and volatility.

(2) Disadvantages of Short Selling

● Default Risk

Since short selling involves borrowing and subsequently returning stocks, significant losses can occur if the stock price rises unexpectedly beyond expectations.

● Ethical Concerns

Some short sellers may intentionally spread negative rumors or false information to artificially drive down stock prices, raising ethical concerns.

● Negative Incentives for Management

If short selling is based on inaccurate rumors, management might prioritize defending the stock price, potentially neglecting core business operations.

● Unfair System

Potential loopholes in the short selling system can be exploited, leading to unfair practices in short selling.

● Unlimited Loss Potential

Losses from short selling can theoretically be unlimited. If the stock price surges unexpectedly beyond initial predictions, it can lead to endless losses.

● Inadequate Regulations

Compared to advanced economies, South Korea's short selling system lacks features like margin requirements, a defined timeframe for short selling, and a fully computerized short selling process, leading to potential unfairness.

5. Utilization of Short Selling

(1) Profit Generation

When anticipating a decline in a stock's price, short selling can be used to generate profits. In fact, many investors abroad leverage this strategy. These investors conduct in-depth research on a specific stock to accurately determine its fair value, ultimately seeking profit. Investing in overvalued companies can often prove challenging in terms of profit generation, making short selling a useful approach.

(2) Portfolio Management

Short selling can be used to manage portfolio risk. When an investor wishes to secure profits while avoiding selling a stock, they can maintain their long position and simultaneously establish a short position. This allows for capital gains while retaining ownership. However, tax and interest expenses must be considered.

(3) Arbitrage Trading

Arbitrage trading also utilizes short selling. Foreign and institutional investors might employ short selling in conjunction with buying futures contracts. This allows for arbitrage opportunities when the spot price is lower than the futures price (contango) or higher than the futures price (backwardation).

(4) Information Utilization

Even without directly engaging in short selling, you can utilize short selling data to gain profits. Short sellers typically possess more information than the average investor. Therefore, if you are uncertain about a stock's direction, reviewing short selling trends can help avoid risky stocks or inform your decision to sell.

(5) Stock Lending Agreements

Through stock lending agreements, you can lend your stock for short selling purposes and receive interest payments. However, the interest income is usually not substantial. Furthermore, short-term investors are more susceptible to potential losses from short sellers. Consequently, this method is more suitable for long-term investors.

(6) Futures Selling and Funds

Funds and ETFs that provide similar effects to selling futures can also be used. Recently, products like inverse funds and reverse funds have emerged, designed to amplify both profits and losses.

6. Risks Associated with Short Selling

(1) Market Imbalance

"The market can remain irrational longer than you can remain solvent." - John Maynard Keynes

This quote implies that even if you are certain the market will move in a predicted direction, it can still move contrary to your expectations, potentially resulting in losses.

(2) Unlimited Losses

Theoretically, the maximum profit from short selling is 100%, but the maximum loss is unlimited. You have to pay interest when borrowing stocks, and since it involves profiting from price differences, short selling can become increasingly disadvantageous over time.

(3) Difficulty in Short-Term Predictions

Short-term stock price predictions are challenging, and many investors struggle to accurately predict them. Historically, numerous investors have experienced losses when the market did not behave as expected.

(4) Impact of Bull Markets

Even if a particular stock is considered undesirable, it tends to rise along with the overall market during a bull market. Short selling carries significant risk during periods of market uptrends.

(5) Prohibition Measures

During economic crises, governments sometimes temporarily ban short selling as a policy measure. This can lead to significant losses if you are unable to liquidate your short positions. Short selling is a strategy that offers high risk alongside the potential for high returns, but careful consideration and thorough information gathering are essential. Given the difficulty of short-term predictions, caution is particularly important. It's crucial to devise a detailed short selling plan based on your investment objectives and risk tolerance.