The concept of short selling
Selling short is a financial tool investors can use to create a return even if the value of a single stock is declining or when the stock market has a downward trend. In finance one distinguishes between going long and going short, where going long refers to an investor who buys stocks, believing that the price of the stock will increase in the future. On the other hand, when an investor goes short, he foresees a decline in the share price.
We will provide an example of how to conduct a short sale.
Step 1 – Investor A, borrows 10 000 stocks in company X. His broker will lend him the stocks.
Step 2 – He immediately sells the stocks for 10 SEK each, receiving 100 000 SEK less commission fees.
Step 3 – A week later, the share price has decreased to 9 SEK and investor A wants to close the short by buying back the same amount of shares, also known as covering.
Step 4 – He pays 90 000 SEK plus commission and return the shares to the broker making a profit of 10 000 less the commission fees. Usually the broker also charges an interest fee for lending the shares.
There is normally not an agreed time of the closure of the short sale. The short seller can therefore return the shares when he thinks it is appropriate.
Motives behind short selling
Ek and Petersson (1994) describe three strategic incentives behind short selling. (1) Arbitrage; the investor uses short selling to benefit from market inefficiency arising from mispricing of stocks and other financial instruments, (2) hedging; the investor uses short selling to reduce or cancel out risk in other investments and (3) speculation; as the name refers to, this is a purely speculative strategy. The investor does not have the risk-free return, arbitrage, or insurance, hedge, but in return the yield can be relatively high. This is, however, a highly risky activity and only a small proportion of short selling is used for this purpose.
Another motive for going short is described by Averil, Morse and Stice (1990) and is referred to as “shorting against the box”. This concept implies short selling securities the investor already own. Holding a short and long position simultaneously results in a neutral position where the gains in the stock will be equal to the losses. The purpose of shorting against the box is to delay taxes. If an investor makes a large profit during e.g. the first three quarters of a year and then speculates that the market will decline during the fourth quarter and the following year it can be assumed that he would like to sell off his shares. If the investor shorts against the box, he can wait until next financial year before he collects parts of the gain, which can put him in a lower tax bracket in the current year without risking that the shares will decrease in value.
Expected returns and risks
The expected return from a short sale can never be greater than 100 percent under the assumption that the price of the shorted security has fallen to zero. This is, however, not likely to happen although financial markets can in periods of disturbance be highly volatile, causing stocks to fluctuate to a great extent as we have seen during the fall of 2008. Short selling is, on the other hand, a risky business since there is no limit of the investor’s potential losses. There is no theoretical end to how high prices can go, above statements are illustrated in figure 3-1. If the price of a security increases rapidly, short sellers may be forced to cover their positions. If many short sellers buy back their shares at the same time, the price of the stock can be pushed higher than normal making it devastating for the investor, also known as short squeeze (D’Avolio, 2002). Also, looking from a historical perspective, stock prices tend to increase over time which indicates that, ceteris paribus, holding a short position involves more risk than holding a long position.
1.1.1 History of short selling regulations in Sweden
2.1 Research approach
2.2 Research metho
2.3 Sample and limitations
2.4 Data collection
2.5 Data analysis .
3 Theoretical framework
3.1 Efficient market hypothesis
3.2 The concept of short selling
3.3 Regulations in foreign countries
3.4 Previous research
4 Empirical findings and analysis
4.1 Statistical analysis
4.2 Hedge fund’s perspective
4.1 The Financial Supervisory Board
4.2 Further analysis
5.2 Future Research
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Short sale restrictions The Swedish perspective