About Short Selling

Taking the mystery out of short selling

Short selling is a method of profiting from a stock that falls in price. While it may seem counterintuitive, profiting from a falling stock is actually quite straightforward. The short-seller borrows shares he doesn’t own, and sells them immediately. At a later date, after the shares have fallen in price, the short-seller buys them back, and returns them to the lender. (Please see the detailed example of such a transaction below).

From an individual security basis, profiting from a falling stock is one motivation for shorting a stock. From a portfolio standpoint, there is another, equally important reason to do so: to hedge the risk of another stock held long.

Here is an example of how short selling works:

Suppose a manager does not like the short-term prospects of CanBank.  The manager will choose to “short sell” 100 shares of CanBank, currently trading at $50.  The manager begins by asking his broker/security lender if he can borrow 100 shares of CanBank, which he will later return.

The manager then sells the borrowed shares on the TSX at $50 per share, thus raising $5,000 in cash, cash that he did not have before.

One month later, CanBank is trading at $40 per share.  The Manager decides to “cover” his short sale of CanBank.  To do this, the Manager buys 100 shares of CanBank on the TSX at $40 per share, for a total cost of $4,000.

The Manager returns the 100 shares of CanBank to his broker/security lender, thus replacing the shares that he initially borrowed.

The Manager has made $1,000 from this trade, which is the difference between the short sale proceeds of $5,000 and the $4,000 it cost to repurchase and replace the borrowed shares.

In other words, the manager has made $1000 from a stock that has gone down in value, thus demonstrating one of the potential benefits of short selling.

Short selling is key to a market neutral portfolio as it allows the manager to balance short positions against those held long, thereby canceling out general market movements.

It should be noted that while shorting is done for two reasons, to gain from falling stocks and to hedge against stocks held long, the SciVest Market Neutral Equity Fund uses shorting primarily for the latter reason. While it is hoped that gains will be made from our “shorts”, these shorts exist first and foremost to lower the volatility of the overall portfolio.