What is a short selling?
The traditional way to profit from stock trading is to “buy low and sell high” but investors do it in reverse order when they wish to sell short. Short selling is when investors who sell short and believe the price of the stock will decrease in value, and it is an advanced strategy that only experienced traders and investors should take. Short selling involves selling borrowed shares of a stock with the belief that the price will drop, at which point you want to buy shares at a lower price to repay what you borrowed.
Suppose an investor thinks Saudi Aramco is overvalued at SAR 60 per share and will decline in price. Here, the investor could borrow 10 shares of Saudi Aramco from their broker and then sell the shares for the current market price of SAR 60. If the stock goes down to SAR 30, the investor could buy the 10 shares back at this price, return the borrowed shares to their broker, and net SAR 300 (SAR 600 - SAR 300). However, if Saudi Aramco’s share price rises to SAR 90, the investor would lose SAR 300 (SAR 600 - SAR 900).
Are there any restrictions on short selling in the SA?
Tadawul announced the short-selling option in April 2017, and it was the first in the Gulf region to introduce short selling for institutional investors on its platform in an effort to attract international investors and appeal to index providers, such as MSCI Inc. In March 2021, Tadawul widened access to short-selling and stock-lending which allowed all types of investors to conduct short selling and securities borrowing and lending activities with specific conditions. However, Tadawul also imposed new limits on eligible listed securities for short selling, including:
- Short ratio to the average daily traded volume of any security should not exceed 10 days and total net short positions must not exceed 10% of the issued securities of any issue, and the Tadawul reserves the right to specify which securities might be made available for short-selling transactions. (Note: The short ratio is the number of shorted shares divided by average daily trading volume, and it's used to gauge investor sentiment regarding a public company or the market as a whole.)
- Tadawul and Securities Depository Center Company also amended securities borrowing and lending (SBL) provisions relating to return of borrowed securities and collateral. Where failed to return borrowed securities or collateral as per terms of SBL agreement, the custody member needs to notify the Depository Center which will terminate SBL transaction.
In introducing the new short-selling function to the exchange, the authorities have sought to balance the desire to deepen the market and attract liquidity with the necessity of protecting investors and minimizing market risk.
Benefits of short selling
- Leverage. Because investors can sell short with margin trading, only putting up a percentage of the total value of the stock they’re trading, which can make more money with a smaller investment.
- More profit opportunity. Investors can make money not only from stock price increases but also from stock price declines.
- Hedge. More experienced investors sometimes use short selling as a short-term hedging tactic to offset the risk of another investment.
Risks of shorting selling
- Unlimited potential losses. When investors take a long position of shares, the downside is limited to 100% of the money they invested. However, when investors short a stock, the stock price keeps rising, which means there is no upper limit to the amount you'd have to pay to replace the borrowed shares.
- Expensive trading cost. Generally, short selling carries greater expenses than a traditional long purchase of stock. Most long purchases are carried out using cash accounts, but short-selling is undertaken with borrowed funds via margin accounts, which means that interest charges apply.
- Short squeeze. A short squeeze happens when many investors bet against a stock but the stock price shoots up instead. That increase causes short-sellers to attempt to exit their investment, which requires buying the stock. The rush of buy orders from short-sellers boosts demand for the stock, which can push the stock's price up even higher. The most obvious risk in the context of a market dominated by retail investors, such as the Tadawul, is the scale of losses that can be accrued on an unsuccessful short trade.
- Short-covering rally. Short covering refers to the purchase of securities by an investor to close a short position in the stock market. During a short-covering rally, investors who are short-selling a specific stock rush to close their short positions and buy back the stock as the stock rises instead of falls. This trading activity can drive the stock price even higher, leading even more short sellers to rush to close their short positions before the price gets even higher.
When is the best time to sell short?
Short selling is not a strategy many investors use, largely because the stock market tends to go up in the long run, even if it is occasionally interrupted by bear markets in which stocks tumble significantly. So buying stocks is less risky than short selling, and short selling may only make sense in certain situations. Here are three example situations in which short selling may have the potential to be profitable:
- When the market is bearish. Short selling is the most profitable when the market declines sharply. For example, the short sellers made fat profits during the global crisis of 2008 - 2009.
- When fundamentals worsen. Macroeconomic and microeconomic fundamentals can go weak, and the deteriorating data can indicate a potential economic slowdown and bearish market sentiments.
- When technical indicators predict a bearish trend. Trend analysis is an aspect of technical analysis that tries to predict the future movement of a stock based on past data. When the market predicts a bearish trend, the stock prices will move downwards. Therefore, this may be the best time for a short seller to kick-start their investment strategy.
Summary:
- Short selling is an investment strategy designed to profit from the price of the stock going down, rather than up.
- Short selling involves selling borrowed shares of a stock with the belief that the price will drop, at which point you want to buy shares at a lower price to repay what you borrowed.
- Tadawul announced the short-selling option in April 2017, and it was the first in the Gulf region to introduce short-selling for institutional investors.
- In March 2021, Tadawul widened access to short-selling and stock-lending which allowed all types of investors to conduct short-selling and securities borrowing and lending activities with specific conditions.
- Short selling has more risks than traditional stock purchases since it can lose much more than 100% of the original investment.
- Short selling allows investors to only put up a percentage of the total value of the stock they’re trading, so they can make more money with a smaller investment.
