What are short sales?
Short selling is the sale of underlying assets that the seller does not own. He lends them instead and returns them at an agreed time.
The intention behind this is to later buy the underlyings cheaply on the stock exchange. The difference between the actual purchase price and the selling price to the broker who lent the underlying assets is the gain on a short sale.
Short sales can be made with equities, commodities, foreign exchange and derivatives in both spot and forward transactions.
Legal basis for short selling
Although the short sale is often referred to as a “bet” on stock prices, it is not legally a game. However, there is no legal definition for the short sale. This means that the practice of short selling is not explicitly defined in any law.
Under civil law, short sales in Germany are covered by purchase contract law. According to this, purchase contracts may be closed, even if the buyer may actually make the purchase later.
However, the Civil Code does not exempt the buyer from his obligation to purchase, should the conditions not be met.
In principle, short sales are classified as forward exchange transactions, since this form of stock trading involves the typical market price risk for forward transactions.
According to Section 59 of the Investment Act (InvG), investment companies are not allowed to short sell. This is because the securities must be owned by the Company at the time of sale. In a short sale, they do not count as special assets.
The investment company may not sell any assets for joint account of the investors in accordance with §§ 47, 48 and 50 if the respective assets do not belong to the fund at the time of the conclusion of the transaction; § 51 remains unaffected. The effectiveness of the legal transaction is not affected by a violation of sentence 1.
State restrictions on short selling
States have the ability to limit short selling. In Germany, the BaFin is responsible for such temporary restrictions. Other countries have similar safeguards. In Europe, the European Securities and Markets Authority has banned them since 2012.
Uncovered short sales have been prohibited since 2010 under section 30 of the German Securities Trading Act (WpHG). This regulation has been in force throughout the EU since 2012. There, the ban on short selling on the EU Short Selling Regulation (EU Short Selling Regulation) is based on Article 12 and on various transparency regimes.
In total, there are four implementing regulations within the European Union which specify the provisions of the EU Short Selling Regulation. These rules include both the definitions and the implementing and regulatory standards. There are also rules for compliance with regulatory technical standards.
Since the financial crisis of 2007, short selling of financial stocks has been prohibited in the following countries: Germany, US, UK, France, Canada, Taiwan, Portugal, Ireland and Australia.
This is how a short sale works
Short sales are possible as a spot transaction or futures transaction. In both cases, the short seller buys shares from a broker and resells them at a later date.
He keeps a so-called “short position”. The short seller hopes for a lower stock market price. The difference between the selling price and the purchase price of the borrowed shares minus the rental fee is the profit.
- Short sale as cash transaction: If the short sale is carried out in this form, it does not differ from a conventional sale in terms of the purchase and processing. In this case, a short seller must deliver the sold value within a short time frame. These periods are usually between two and three trading days. In order to deliver the securities within this period, he must borrow them.
- Short sale as a forward transaction: When making a short sale as a forward transaction, the short seller must deliver only at a fixed date in the future. This means he has more time to stock up on the capital needed to buy underlying assets.
Covered and uncovered short sales
When short selling is covered, the actors borrow equity or other underlying from brokers or security holders for a fixed period of time. These papers sell them in the market.
In the case of an uncovered short sale, the sellers are neither in possession of the underlying nor have they borrowed the underlying assets. This form of short selling can lead to very strong price effects.
No uncovered empty purchases in Germany
For example, it is possible for a stock trader to sell shares in the market through uncovered short sales that do not exist in this quantity at all.
Uncovered short sales are possible because the delivery deadline for the securities is several days. Uncovered short sales are prohibited in Germany.
The purpose of short sales
Short sales are first of all securities transactions that profit from falling shares. Thus, a meaning of the short sale is the profit optimization of a depot. At the same time, short sales can hedge other forward transactions or stock market transactions as a short position.
Private investors also use short selling for two reasons: First of all, short selling can secure their own portfolio. On the other hand, they can provide for higher profits.
Hedge funds also use short selling to hedge their speculation. In this sense, short sales fulfill the literal meaning of these funds (English: to hedge = secure in German).
The impact of short selling on the market
How strongly short selling affects the market is disputed among experts. Some scientists do not see any impact of short selling on the market.
However, critical voices assume that short sellers are deliberately trying to squeeze the prices of the positions they hold short in order to maximize their profits.
The critics of short selling, therefore, assume that large investors, for example, deliberately spread false reports about companies, so that the stock price falls. Short positions, for other experts, are important correctives in the market as they prevent upward price rises.
The origin of short sales
The history of short selling dates back to 1602. At that time, a Dutch trader invested in and acquired shares in a Dutch trading company. Due to political and economic constraints, the company was unable to pay dividends seven years later.
Thus, the dealer Issac Le Maire decided to sell more shares in the trading company than he actually owned. In this way, he wanted to compensate for the dividend loss. This was the first time in history a short sale has been completed.
Initially, short selling on the stock exchanges was banned, but in the long run this form of stock speculation continued. A big break for the short selling trade took place in the wake of the global economic crisis in the late 1920s. Thus, short selling on falling prices in the US were prohibited. The ban was maintained until 2007.
In the same year and in subsequent years, short selling has again played a tragic role in the global financial crisis. Not least because of this, this form of securities trading is still controversial.
the market participants
The short sellers group is usually divided among the following market participants:
- Private Investors : Private investors can place or participate in short selling via brokers or other stock traders. They use short sales to minimize their risk of loss or to optimize their profits.
- Large Institutions : Large institutions often use short selling to smooth other stock exchanges.
- Hedge Funds : Hedge funds traditionally use short selling to maximize returns.
These providers lend stocks for short sales
Typically, large pension funds lend to short-selling stocks. You will receive a fee from the short sellers. These fees provide additional profits for these funds.
Availability of the shares
The precondition for lending stocks is above all that the shares in question are available. Thus, short selling always depends on existing shares.
This is how the transaction is handled
Short sales can take place via different players.
- Broker : If a broker is used for short selling, sells or buys shares on behalf of the client.
- CFD : Short sales can be made in the form of contracts for difference.
- Broker : Brokers can also be used to place short sales. In Germany, for example, there are the brokers Cortal Consors, Lynx or OnVista Bank, through which short sales can be processed.
Risk and return
Short selling is associated with high risk for investors. They are among the speculative securities trades as falling prices are set.
Anyone who invests capital in short sales runs the risk of total loss. A short seller can even make further losses if, for example, the prices did not fall, but rose massively.
Such a “short squeeze” occurred in 2008, when the VW share rose above average because Porsche had announced that it would take over Volkswagen. Short sellers, who at that time had bet on a falling price at VW, now had to deliver their share packages at a significantly higher price.
Every short sale is a kind of “bet” on falling prices. Thus, the risk of profit or loss depends heavily on the performance of the company or the price. Most factors cannot be influenced by investors.
When investing in short sales, investors must also consider that many fees are due. For example, they have to pay the broker or broker and interest on the borrowed underlying assets.
The profit from the short sale must first cover all these costs until the investor actually benefits from the sale. For this reason, short selling usually requires a higher level of risk right from the start in order to make any profit. At the same time, risk increases the risk of losses.
Dividends and short selling
Some investors try to short sell on the dividend record date. They assume that the stock of a company will decline on the day of payment of the dividend.
As a rule, the stock is then listed minus the dividend paid per share. A bet on falling prices seems very safe in this case. However, a shareholders’ meeting can also bring positive company news in addition to the dividend payment.
These provide for a strong price increase, which goes beyond the deducted dividend. In this case, the short seller would even make a loss. For this reason, the strategy of using short selling on the dividend record date is not recommended.
Minimize risks by type of coverage
In Germany, only covered short sales may be carried out. In this way, the risk of loss is minimized in advance. The cover is usually provided by securities lending or a securities repurchase agreement. The securities are first transferred to the short seller.
In addition, short sales can also be covered by call options, same-day coverage or derivatives.