What is short selling?

Years after initial plans began in 2018, the Philippine Stock Exchange (PSE) will finally launch its short selling program on October 23. The domestic short selling regime has lagged peers in the region given lengthy delays in the approval process for its rules. Developed stock markets in Asia including Singapore, Malaysia, Indonesia, Thailand, and Hong Kong already have a short selling program in place for years.

The commonly understood way an investor can profit from the stock market is when they have a long position on a stock. This means an investor buys a stock anticipating that its price will rise over time. When it does the investor sells the stock later for a profit.

But stocks do not have to go up for investors to make profit. Investors can also profit if the stock price falls through short selling.

What is short selling?

In short selling, a position is opened by borrowing shares of a stock that the investor believes will decrease in value in the future. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the investor is betting that the price will continue to decline, and they can purchase the shares at a lower cost.

In other words, short sellers earn when a stock drops in price rather than when it goes up.

Let us create a scenario: say an investor expects the price of the stock of XYZ company to decline. He borrows 10,000 XYZ shares to sell at a current price of PHP 10 per share or a total of PHP 100,000. After three weeks, the price of XYZ drops to PHP 6 and the investor buys back 10,000 shares for only PHP 60,000. The investor makes a profit of PHP 4 per share or PHP 40,000 for 10,000 shares. He closes his short position and returns the borrowed shares to the lender.

What are the guidelines for short selling transactions?

The PSE has declared the immediate effectivity of its Guidelines for Short Selling Transactions. This comes after regulators have given their go signal on critical components of securities borrowing and lending (SBL).

SBL is the borrowing of stocks from a lender’s portfolio of assets to a borrower who needs the stocks to meet settlement obligations or to support trading strategies. Short selling can only function if an SBL program is in place.

The PSE also announced that it had updated the eligible securities in its short selling guidelines to include members of the PSE MidCap and PSE Dividend Yield indices. Initially, only securities comprising the PSE Index and exchange traded funds were considered eligible securities for short selling.

Securities can be shorted if the number of shares that have been sold short and remain outstanding is less than or equal to 10% of its total shares. This is known as the short interest ratio. If a security exceeds this 10% limit, it cannot be shorted until it falls back below this threshold.

The PSE shall publish an end-of-day report on short selling transactions and outstanding short position. The report contains a short volume and value traded per eligible security and per previously eligible security, as well as the aggregate short position of the securities.

What are the risks of short selling?

1. Price risk – Short selling strategies must be opportunistic and well timed. The investor’s desired price may not materialize (i.e., the share price did not decline as expected).
2. Short squeeze – Rapid increase in share price will “squeeze” or force investors out of their short positions to cut losses.

What are the benefits of short selling?

1. Development of the SBL program – SBL is at the core of short selling because an investor must borrow shares first.
2. Generation of trading activity and improvement in liquidity – Any new buying or selling that comes into a market adds liquidity. In times of a bear market, short sellers will provide additional liquidity.
3. Unlocking more investment products – The launch of short selling is a step towards introducing other hedging instruments such as derivatives.
4. Promotion of efficient price discovery – Short selling is a tool which allows investors to have long or short views of the market. In effect, it enables better valuation of shares and the mitigation of price bubbles.