Equity Short Selling

This month’s Wealth Pipeline looks at short selling of equities (shares).  

Equity Short Selling

Short selling is the selling of a security that the investor/trader does not own.  If you own a stock you are said to be ‘long’.    

An investor/trader will take a short position if they are anticipating a decrease in the price of that security or if they believe the security will increase less than a security that they have an equivalent valued long position in (a relative value trade).

When an Australian share is short sold it is a requirement that the share sold is borrowed to cover the short position.  Shares are usually borrowed from fund managers or superannuation funds.  

If there is a stock lender willing to cover a short position there are no time limits on the duration of the short position.

Stock lenders will charge a fee and any dividends that are paid in the time that they are held by the borrower will be payable to the lender.  The negotiated dividend amount will depend on the tax situation of the stock lender.

A Simple Example

Bob thinks that the outlook for resources is bleak and believes that shares in a resource company “XYZ Mining” are about to fall.

Bob sells 10,000 shares in XYZ Mining at $1.00 receiving proceeds of $10,000. 

Fast forward 6 months and Bob’s outlook for XYZ is correct, XYZ Mining announces that outputs will fall which sends their share price plummeting to $0.67. 

Bob closes his short position by purchasing 10,000 shares in XYZ at $0.67 to fill the short position for a cost of $6,700.  This represents a profit of $3,300 less stocking lending fees (holding revenue ignored). 

A Relative Value Trade Example

Bob thinks that Bank A is gaining ground on Bank B and will soon be Australia’s leading bank.  Bob thinks that the best way to make money from his prediction is to create a pair trade as he believes Bank B’s share price will increase by less than Bank A’s share price increase.  A pair trade is a relative value trade involving companies who are from the same industry in direct competition.  To action the pair trade, Bob sells 1,000 Bank B shares at $30 and purchases 1,000 Bank A shares at $30.

In 1 year’s time, Bob’s prediction has proved accurate and Bank A is now Australia’s largest bank, however Bank B is still producing strong profits.  Bank B’s share price is now $35 and Bank A’s is $40.

After closing out both his long and short positions, Bob’s total profit for this pair trade is $5,000 less stock lending fees (holding fees and dividends ignored).

How Do Retail Clients Take Advantage of This?

We do not believe that retail clients can cost effectively short equities on the ASX without taking unnecessary counterparty risks.  We generally recommend retail clients participate in this type of investment through managed funds.