Opportunities during economic crises: How does shorting work?

Author: Eric Liu
Editor: Yihan (Bradley) Tian

Image Source: Canva
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When it comes to bearish markets or even black swan occasions, many think that the optimized solution for investors is to hold onto cash in order to preserve the value of assets. Meanwhile, some opportunists seek to profit through a process contrary to conventional buying and selling, known as shorting.
 
What is shorting?

Professionally speaking, shorting is an investment term and an operation mode of financial assets. In contrast to going long, the action of buying a stock and expecting it to rise in value, the logical steps of shorting include:
1. Borrow the target asset (stock, future, etc.)
2. Sell it to obtain cash
3. After a period of time, spend cash to buy the target asset at a lower price
4. Return the borrowed asset. 
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Image Source: Grochim

Common functions of short selling include speculative investing, financing, and hedging.  Among them, speculative investment refers to the expectation that the future market will fall, then sell high and buy low. The specific process is to sell the stock borrowed at the current price, buy, and then return the borrowed asset after the market falls, eventually profiting from the difference in the stock price. The characteristic of this trading method is selling before buying. In fact, it's a bit like the destocking transaction model in business. This model can be profitable in the wave of price decline. When the price of the asset declines, the cost of buying the target asset will be lower than the initial amount gained when the borrowed assets are first sold, thus generating profit for the short seller.
 
Why is the lender willing to lend the assets?
The lender can be any investor or assets holder. Usually, the interest rate of the lent asset is much higher than the loan interest rate (standard market interest rate) and will continue to float according to market sentiment: if the possibility of falling is high, then the interest rate is high, and vice versa. Therefore, if the price of the asset does not fall, the lender can obtain a profit far exceeding the market interest rate.
 
The lender, in many cases, can also be securities companies. Some companies hold certain stocks and intend to hold them for long-term value investment or due to that they cannot be sold immediately. Regardless, the companies do not intend to sell these stocks in the short term. These companies lend portions of their stocks to the short sellers so that in addition to the stock bid-ask spread and dividend income, additional loan interest, which is also the main motivation for securities companies to develop securities lending, can also be obtained.
 
Who are the short sellers in the market?
In a free, capitalist market, investors are the judge of the companies. Shorting provides investors the opportunity and motivation to dip inside stories that companies may be trying to cover. They can express their positive expectations by going long while they can also look down on a company by going short.
 
The operations which aim to short the companies with flaws have become a complete industrial chain with unprecedentedly inviting profits. The participants in this chain include:

1. The supervising authorities: government organizations like the U.S. Securities and Exchange Commission (SEC) are responsible for daily operation, supervision, regulation, and penalty decisions pertaining to the market.
2. Law firms: they help individual investors to accuse companies.
3. Accounting firms: they audit the companies’ accounts to provide evidence for a positive or negative outlook for them.
4. Research Organizations: analysts in these organizations investigate companies, gather evidence and data, and publish forecasting reports. Examples of such include Muddy Water Research, Citron Research, etc.
5. Whistleblowers: they are the so-called ‘snitches’ who are previous employees that got cut or left. They publish negative and, often times, illicit information inaccessible to the public.

 
Conclusion
Short sellers are always misunderstood as the devils of the market. While these generalizations are not entirely fabricated, the reality is that short seller are also the guardians of order in financial world as they reveal and rectify faulty schemes built by companies trying to maintain facades of glory that helps them reap unjustified profit from the economy. Without the necessary revelations of the hidden dark spots, individual investors are nothing but “silent lambs” susceptible to manipulation by larger shareholders in the market.