Short Selling

What is Short Selling?

Short sellers follow the conventional wisdom, according to which you should buy low and sell high. Here, however, the stock is sold first and bought later!

Short sellers borrow shares and sell them on the market with the idea of buying them back later at a lower price. To short sell a stock, it is necessary to borrow it from a broker and immediately sell it on the market; then you have to deliver the stock back to the counterparty by buying the same amount of shares later on the open market. If the repurchasing price is lower than the initial selling price there is a profit, otherwise the manager will suffer a loss.

Short sellers also make money from the liquidity interest originating from selling the stock short, a liquidity which is held as restricted credit by the brokerage company lending the shares: the short seller will earn interest on these cash proceeds, called short interest rebate.

The outcome of the transaction depends on the manager’s stock picking ability and market timing. Profits from short sales are taxed at the short-term capital gain rate, irrespective of how long the position remained open. Unlike traditional investors, who look for undervalued companies, short selling managers look for overvalued ones. Short selling hedge funds do not disclose the names of the companies they are selling short to their investors, for fear that the market might stand in the way and try to cause a squeeze. It is common practice among hedge fund managers to comment on short sales only after they have been closed out.

If a manager believes a stock is overvalued, he will ask his broker to sell the stock short: the broker will then lend the desired number of shares to the manager, requiring the manager to return them within a given period of time, defined in advance. As soon as the manager receives the shares, he sells them on the open market and receives liquidity that generates an interest income. The broker is compensated based on the loan value, and in any case will require the manager to set up a margin account as a loan collateral.

If the share price goes down, the manager can purchase the stock back at a lower price than he originally sold it for, and can therefore return the shares to the broker, profiting from the difference between the sale price and the following repurchase price, in addition to the interest income he got from the cash proceeds from the short sale of stock. Short selling exposes the short seller to a potential unlimited downside risk: if the share price goes up, he will have to repurchase the stock whatever its price at contract maturity.

Some readers may wonder how is it possible to make money on stock you do not own. Even after this explanation on how short selling works, it may still appear confusing, especially if one tries to compare this mechanism with everyday life. It is actually rather difficult to imagine going to the market to short sell cherries that a grocer is selling at a high price, hoping to buy them later at a lower price!

This review is from: Investment Strategies of Hedge Funds (The Wiley Finance Series)
The best attribute of this book is that it doesn't mislead the book buyer by presenting a big and juicy carrot on its title, only to fail the reader expectations throughout the book. In a nutshell, if you want to know what does mean covertible arbitrage, market neutral, distressed securities, merger arbitrage and so so, you'll get a detailed answer in there.

Chances are, however, the book buyer is searching for sources of inspiration for her own investment portfolio or her hedge fund selection process. In that case, the book is not worth it because it doesn't provide any evidence of what could be the strategies that might benefit the most from the current state in financial markets or which might benefit from future states or under uncertainty, etc. The book is just a compilation of known hedge fund strategies, a technical dictionary if you will, where you get a detailed explanation of this and that but no insight on when or where.