Short selling is an investment technique where an investor sells a stock short, meaning they sell the stock without owning it, and then borrow the stock to cover the sale later. This is done when the investor expects the stock price to decline. By short selling, the investor can profit from the decline in the stock price. However, if the stock price rises instead, the investor will incur a loss.

1. What is the purpose of short selling?

The purpose of short selling is to profit by entering into a transaction with the expectation that the stock price will decline in the future. Once the stock is sold, the investor borrows the stock and returns it to cover the short position, generating a profit. This is a strategy that can be used to make money even in a declining market.

For example, suppose a person, A, expects that a stock, (a), currently priced at ₩10,000, will decline in price. They borrow (a) stock from another person, B, and sell it for ₩10,000. A week later, (a) stock drops to ₩5,000, and A buys the stock back at ₩5,000 to return to B. A has made a profit of ₩5,000 by selling at ₩10,000 and buying back at ₩5,000. This is the basic concept of short selling: borrowing a stock you do not own, selling it, and then buying it back to return.

Does this mean you always make a profit when you short sell?

Stock prices can go up or down. You will make a profit if the stock falls as expected, but you will lose money if it goes up. If you sold it for ₩10,000 after borrowing it, but the price went up to ₩15,000? You will lose more than just ₩5,000, considering the fees. Some may think, "Why not just wait until it goes down?" You may think that, but like money, stocks also have a borrowing period. If you can't pay back within the period, you will have to pay interest or face other penalties.

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

Naked short selling refers to short selling without borrowing the stock first. This is generally prohibited or heavily regulated because it can disrupt the market. In most countries, naked short selling is illegal. On the other hand, covered short selling involves borrowing the stock first, selling it, and then buying it back to return it later.

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

Short selling is one of many investment strategies used in the stock market. The stock market offers various opportunities for investors, and short selling is a tool for investors who expect the stock price to decline.

4. What are the pros and cons of short selling?

(1) Advantages of short selling

● Improved efficiency of the stock market

Stock prices are determined by the balance of buying and selling. Short selling allows investors who believe the stock price will go up and those who believe it will go down to reflect their opinions in the market faster. This helps to improve the efficiency of the stock market.

● Increased liquidity in the stock market

When short selling is available, it's easier to reflect bearish opinions, making transactions easier to complete. This increases liquidity in the stock market.

● Improved price continuity

Short selling leads to more frequent transactions and faster reflection of information, improving the continuity of stock price changes.

● Exposes negative management practices

By short selling, negative management practices can be exposed, leading to disadvantages in terms of stock price and loan terms, making managers accountable. This contributes to increased corporate transparency and promotes sound management.

● Helps with hedging

Short selling allows investors to profit even in a declining market, giving them more control over the direction and volatility of their returns.

(2) Disadvantages of short selling

● Risk of default

Short selling involves borrowing a stock and returning it later, so if the stock price rises unexpectedly, investors can incur significant losses.

● Ethical issues

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

● Negative incentive for managers

If short selling is based on inaccurate rumors, managers may focus on defending the stock price instead of focusing on actual management.

● Unfair system

There are flaws in the short selling system, which can be exploited, leading to unfair use of short selling.

● No limit to losses

Losses from short selling can be unlimited in theory. If the stock price rises beyond expectations, investors can incur endless losses.

● Inadequate regulation

Compared to developed countries, South Korea's short selling system lacks a margin requirement, no set time limit for short selling, and the actual short selling process is not fully computerized, leading to unfairness.

5. Utilization of short selling

(1) Profit generation

When investors expect a stock to decline, they can profit from short selling. Many investors abroad utilize this strategy. They conduct in-depth research on a single stock to determine its accurate fair value and generate profits accordingly. Since it's difficult to profit from investing in an overvalued company, short selling is useful in such cases.

(2) Portfolio management

Short selling can be used to manage portfolio risk. Investors who want to secure profits but don't want to sell stocks can maintain long positions while simultaneously taking short positions. This method allows investors to profit from price differences while retaining ownership, but tax and interest costs need to be considered.

(3) Arbitrage

Short selling is also used in arbitrage. Foreign investors and institutional investors sometimes short sell the spot market when buying futures. This allows them to execute arbitrage transactions 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, investors can use short selling data to generate profits. Short sellers generally have access to more information than ordinary investors. Therefore, if investors are unsure about the direction of the stock price, checking short selling trends can help them avoid risky stocks or determine selling points.

(5) Stock loan agreement

By entering into a stock loan agreement, investors can lend stocks needed for short selling and earn interest. However, the interest earned is relatively low. Also, short-term investors are more likely to suffer losses due to short sellers. This strategy is more suitable for long-term investors.

(6) Futures selling and funds

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

6. Risks of short selling

(1) Market imbalance

"Markets 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 the direction you predicted, it may move in the opposite direction, leading to losses.

(2) Unlimited loss

The maximum profit from short selling is theoretically 100%, but the maximum loss is unlimited. Investors must pay interest when borrowing stocks, and since they are profiting from price differences, the longer they hold the position, the less favorable the situation becomes.

(3) Difficulty in short-term prediction

Predicting short-term stock prices is difficult, and many investors struggle to do so. Many investors have experienced situations where the market did not move as they expected, leading to losses.

(4) Impact of a bull market

Even if a stock is considered poor, it tends to rise along with the entire market during a bull market. Short selling carries significant risk in a rising market.

(5) Prohibition measures

Short selling can be temporarily banned by government policies during economic crises. In such cases, it can be difficult to unwind short positions, leading to significant losses. While short selling offers the potential for high returns along with high risk, careful judgment and thorough information gathering are essential. It's crucial to exercise caution, especially considering the difficulty of short-term predictions. Furthermore, it's important to develop a specific short selling strategy based on your investment goals and risk tolerance.