UKSA education - Shorting

In financial trading you can 'short' all sorts of things. The most common is 'shorting stock', which means selling a stock you don't own. So 'shorting Vodaphone' means selling shares in Vodaphone before you've bought them.

How do you do that?
Actually it is not that difficult. An example from a different trading world:

If you were an antique dealer without any stock and an impatient customer said he wanted a piece of Lalique glass of a certain type and was prepared to pay £1,000 for it, you might commit to sell him one. Then you would rush round the specialist dealers trying to buy one to deliver to your customer. You would have sold something you have not got. And until you found it, you would be 'short Lalique'.

What's more, until you found it you would be at risk. You committed to £1,000 because you reckoned you could find one for £800 (say) and you could make a £200 profit. But what if you could only find one at £1,300? Then you would have lost £300. When you are 'short' you lose money if the price goes up.

As with Lalique, so with Vodaphone. You can 'short Vodaphone'. But you have to deliver what you have sold. Which means you have to buy it, eventually.

Health warning
If you buy Lalique for £1,000 the worst that can happen is you drop it on the floor and lose £1,000. But if you sell for £1,000, and then try to buy what you have sold, and you find there is just one piece of Lalique of the right type in all the world, how much will you have to pay for that piece? From a man who knows you have to have it? £2,000? £10,000? £100,000? Why not £1million?

So short selling is dangerous. Because it is not always obvious what your risks are. And your losses are unlimited. You should not do it.

But, curiously, a skilled trader can use shorting to reduce risk. The ability to 'short' opens up a whole new spectrum of possible trading bets. Not just a bet that a price will fall; but the much subtler bet that price differences will change. When you buy something and simultaneously sell something similar it is called 'hedging'.

Hedging
Let's take an example: Suppose you are an automotive industry specialist, and you come to the view that the prospects for General Motors are very much better than the prospects for Ford. And that this is not reflected in the relative prices of their shares. Perhaps GM have a better model range in the pipeline. Perhaps you perceive that GM have more successfully upgraded their manufacturing techniques. Perhaps you are pessimistic about Ford's labour relations. Whatever.

Now, if you just buy General Motors shares, that might be a good bet. If it's in a stronger position than Ford it is likely to do well. But all sorts of things might go wrong. Rising interest rates might damp consumer demand. There could be a general stock market decline. There could be an oil crisis.

There is a way that you can profit from your specific judgement that GM will do better than Ford. You buy GM stock and you sell the same value of Ford. Now it doesn't matter what happens to the market as a whole, or to automotive stocks as a group. So long as GM does better than Ford you will win.

If you trade both at 60 and Ford declines to 40 while GM falls to 45, you will win 20 on your Ford 'short' and lose 15 on your GM 'long' - net gain of 5. In contrast, if Ford rises to 70 and GM rises to 76 you lose 10 on Ford and gain 16 on GM - net gain of 6.

The business of betting on price differences is called 'arbitrage'.The principle of protecting yourself against certain risks (in this case the general market risk) is called 'hedging'.