Explainer: How stocks are shorted

Canny investors known as “shorters” can make money off tumbling share prices, here’s how it works.

 

While most people will be aware of the concept of buying shares and then holding onto them until the price rises so as to generate a profit, canny investors can also make money when share prices are going in the opposite direction.

This is known within the investment world as “shorting stocks” and investors who specialise in this are referred to as “shorters”.

It is a legal way of investing and is used in many stockmarkets all over the world, including Australia, by sophisticated investors as well as other traders.

Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. The short seller is motivated by the belief that a share price will soon fall, enabling it to be bought back at a lower price to make a profit. The short seller might believe the share price in a company is ripe for a fall because it is being overvalued by the market, that the business has a structural or operational defect, or that the company is hiding bad news or is about to release bad news that will likely send the share price diving.

If these short sellers are wrong, and the share price rises, they can be caught out, or “squeezed”, and are forced to buy the stock to “cover” their short and therefore make a loss on their position.

Listed companies under attack from short sellers often complain they are subject to unfair or co-ordinated attacks to lower their share price, alleging sometimes that short sellers spread rumours or false information in the market (once they are set) to put downward pressure on the share price.

But these short sellers can also be helpful to investors by identifying and publicising companies that are misleading the market. It was a short seller that first spotted the fraud at failed US energy giant Enron.