Benefits and risks of short selling for hedge funds

Of the many strategies employed by hedge funds, short selling is among those that carry the most risk, but it remains a popular strategy for many.

At its most basic, short selling involves a hedge fund borrowing an asset, usually from its prime broker, to then sell to buyers willing to pay the market price. A short seller’s aim is to buy the same asset for less before it has to give the shares back to its prime broker, which is why it's important for hedge fund managers to find the right stocks to short.

A common example of the volatility of short selling is that if the asset price drops on the market the hedge fund will be able to profit on the difference, but if the asset increases in value then it will have to pay the difference, which can lead to severe losses. With that in mind, here are some of the other risks associated with shorting.

Risks of short-selling

Potentially unlimited losses

When an investor takes a long position on a stock or security, they’re betting that the value of the said asset is going to increase – but it’s always possible that they could lose 100% of their initial investment if the asset’s share price falls to zero.

However, with short selling, there’s no limit on how much a hedge fund could stand to lose. In fact, losses on a short position could, in theory, grow infinitely because there’s no limit on how high the share price of an asset can rise.
This could be made worse if multiple institutional investors also had an open short position on the same stock, as it would likely trigger a short squeeze which can be disastrous for hedge funds - unless guaranteed stops are put in place, which are used commonly by institutional investors.

Short squeeze

A short squeeze is a market phenomenon that causes a rapid increase in a security’s share price. This occurs when a high number of investors have an open short position in the security and its share price defies their expectations by increasing in value.

As any increase in the share price can be costly for those shorting the stock, investors with a short position may decide to cut their losses and close their position. This in turn pushes the share price even higher, which will likely cause more short sellers to close their positions. This cycle will likely continue until all short-sellers have closed their positions and the share price for the asset in question is even more inflated.

While the circumstances were slightly different, a short squeeze is essentially what caused the exceptional rise of GameStop’s share price in January 2021. The squeeze was so drastic that many hedge funds shorting the stock lost billions of dollars, while others were forced to stop trading altogether. Although this is an extraordinary example of a short squeeze, it does highlight the risks attached to short-selling – risks that can’t always be accounted for before opening a position.

Margin trading

In order to open a short position on a stock or any other tradable security, investors need a margin account with their prime broker, which enables them to borrow shares and/or money for the purpose of short selling.

Borrowing from lenders poses another set of risks, as this can further boost the rate at which losses accumulate. By having a margin account, hedge funds are required to have a minimum amount of equity in their account.
Furthermore, hedge funds are typically required to pay interest on the borrowed shares for as long as the short position is open, which will weigh against the profits of a successful short – or add to the loss of an unsuccessful one.

The benefits of short selling

The risks of short selling may be grave, but this should only highlight the importance of committing thorough research and due diligence before opening a short position.

When done right, short selling is a strategy proven to generate strong returns for investors. So, what are some of the benefits of short selling?

Leveraged trading

As mentioned, short selling can be an efficient way to generate a strong return on investment – especially if a hedge fund uses margin to open the position, as this provides leverage.

If a hedge fund borrows the shares of the stock or security it wants to short from its prime broker, it doesn’t actually have to lay down much capital to make the investment. This makes short selling a very cost-effective way to make large-scale returns, provided the short is successful.

Hedging

There are huge advantages to shorting stocks and securities as well as turning a profit, in that it’s also an inexpensive way to hedge a portfolio against risk. As the primary goal of hedging is protection, it can protect gains and offset losses in a portfolio. So, while others may be suffering losses incurred in the market, having shorts can help break even and in some cases make money. Generally, less money is involved with shorting and therefore investors can use leverage to benefit from opportunities for further investment and gain.

This would usually be used as part of a long-term strategy where a hedge fund already has a long position on a security, and therefore can maximise against risks and be money efficient.

For example, a hedge fund may plan to hold a particular stock for 12 months before closing its position, but during that time there may be an unexpected development that poses a risk to the overall performance of the stock. In such a scenario, the hedge fund may decide to offset some of that risk by taking a contrary position on the stock, so if its share price does start to fall, the hedge fund’s portfolio won’t be adversely affected.