WITH the Jamaica Stock Exchange (JSE) seeking to implement short selling later this year, now would be a great time to go over what this feature is and how you can make money from it.

Currently, the only way someone can make money on the JSE is through dividends and from capital appreciation, which involves buying a listed security at a lower price and selling it at a higher price. As a result, at the moment there’s no way for someone to make money on the decline of a stock price except for averaging down and selling the stock.

Averaging down involves buying more units at the reduced price, which brings down the investor’s average price on the stock. Thus, if someone bought 10,000 shares of a stock at $3 and bought another 10,000 shares at $2.30 the average price becomes $2.65, which makes it easier to break even. Selling the stock involves the possible realisation of a loss, which makes it harder to recoup the capital depending on the magnitude of the loss. In other words, one would need to make a 67 per cent gain to recover from a 40 per cent loss.

Some traders also employ a strategy of selling a stock as it falls and buying it back at a perceived low, which sometimes results in them owning more shares of the same stock at a lower average price. However, this is not a guaranteed process with a quick rally in the price, meaning that one would have to buy it back at a higher price than at which it was sold.

This is where short selling comes into play. When you buy a stock and hold it, expecting it to increase in value, this is considered going “long” on the stock. Short selling is the opposite, whereby you borrow shares from your broker, sell them on the open market at a high price, and buy them back at a lower price. The difference between these two prices is the profit for someone who shorts a stock.

So, a local example could be in reference to NCB Financial Group (NCBFG) Limited in the last five months. On May 11 it closed at $74.88 and subsequently hit a 52-week low of $64 on July 12 when it closed at $65.36. A person who was long on the stock would have had an unrealised loss of 12.71 per cent. If “shorting” was available during the period a trader could have sold NCBFG’s stock at $75 and bought it back at $65 in the same time frame, which would net them a profit of $10 per share or 13.33 per cent.

While this is perfect in a bear market in which prices are generally trending down, short selling carries its own inherent risks as well. Whereas a stock price can go up in perpetuity to any level — which benefits someone who owns the stock — this is the worst nightmare of a short seller because they begin to incur losses once the stock price trades above that at which they sold it. A short seller can only make up to 100 per cent on any stock that is short, compared to a person who goes long on a stock and can possibly see as much as 700 per cent in a year like what Tesla shareholders experienced in 2020.

The other caveat is your broker having shares available to lend you to execute the short trade. While this is one headache, what happens when the stock is thinly traded or illiquid is that your unrealised gain can become a realised loss when you purchase at a premium to what you sold the stock for. When a dividend is paid by the company you decided to short, you can be required to pay for that dividend as well.

Although some of these disadvantages sound scary, short selling adds a balancing element to the market since everyone can express their position in either direction of the stock. It also adds a new dynamic to the market as there can be more trades while compensating more participants. So, where the short seller can make money on the stock price going down, the person whose shares were lent out can earn interest on those shares.

Interactive Brokers (IBKR) has a facility called the stock yield enhancement programme which lets investors lend out their fully paid shares and earn half of the interest that IBKR collects from the short seller. The owners of these shares receive US treasuries or cash as collateral, which acts as a risk-mitigation measure wherein the short seller cannot return the shares to the owner.

“The fact is that short selling is a component of market development. It has the risk, of course, that persons will potentially benefit from prices going down, but with a market — and all markets — you do want investors to express their investment outlook both in the buying and selling of stocks. We want both expressions to be shared,” said JSE Chairman Julian Mair at the JSE annual general meeting held on June 22.