Short Selling Explained
By PAIP Canada staff
A few weeks ago Toronto-Dominion Bank (TSX:TD)(NYSE:TD) saw a decline in its share price as a result of becoming the most shorted bank in North America. Essentially investors were betting against the bank, hoping for a decline in the share price.
Simply put, short selling is selling high and buying low (instead of buying low and selling high).
For conventional investors, the goal is to purchase shares at a low price, hold them for a period of time, and then sell at a higher price. Along the way, the investor may also receive dividends.
Short selling is the mirror image of that.
When taking a short position, one will sell shares they do not own, thereby creating a negative balance in their account. Instead of owning 200 shares of a company in their portfolio, they are negative 200 shares. Eventually, the investor will want to close their position, thereby returning their account to a zero balance. With short selling, the investor must buy shares to offset their negative position. The selling happens first, and the buying happens later. If shares declined in value, then the profit is the difference in price. If shares increased in value, the loss is the change in the share price.
Where short selling becomes interesting is when the investor must “borrow” the shares to sell in the open market. Given that this creates a negative balance, interest will be charged on the amount borrowed, and the other investor has no idea that their shares have been “lent out” to a short seller. It’s simply a part of a well-functioning financial market.
For those who don’t agree with the premise of short selling, there can be benefits. When shares are shorted, those with a negative sentiment towards a security are able to create downward pressure on the share price, rather than seeing it rise further. Assuming they are correct and shares later fall in value, the short sellers would then “cover” their short positions, putting upward pressure on the stock price. Essentially, by having to return one’s position to zero, the short seller must buy shares, creating demand (and upward pressure on the share price). The argument in favor of short selling is that it creates positive momentum (when there is a large drop in a share price), and the opposite when share prices are too far disconnected from their intrinsic value. It can easily be argued that short sellers minimize the long-term volatility (or range) of a share price.