Understanding Short Selling

PRUDENTIAL INVESTMENTS, A PGIM BUSINESS
EQUITY PRIMER
An educational series for today’s investor.
WHAT IS SHORT SELLING
“Buy low and sell high” is the traditional strategy used by most equity investors.
But what if the stock price declines? Can an investor still profit? By implementing
an investment strategy called short selling, an investor can “short” the stock in
anticipation of the stock’s price declining.
HOW SHORT SELLING WORKS
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Short selling is a relatively straightforward concept. Shorting involves selling borrowed
shares and then buying the shares back and returning them to the lender. As shown
in the figure below, if the price drops, the investor can buy back the shares at the
lower price and may make a profit on the difference. However, if the price increases,
the investor must buy back the shares at the higher price, causing them to lose
money. Since an increase in a stock’s price is potentially unlimited, the potential
loss is
also unlimited.
Borrow the Shares
Sell the Stock on the
Open Market
$50
ABC Stock valued at $50
ABC Stock
Borrower
Borrower
Lender
Borrower
Open Market
Buy Back the Stock
Give Back the Stock
ABC Stock
ABC Stock
Example 1. $20 (price decline)
Realize Profit or Loss
Example 2. $80 (price increase)
For illustrative purposes only.
Open Market
Borrower
Example 1. $50 – $20 = +$30
Example 2. $50 – $80 = –$30
Lender
EQUITY PRIMER
INVESTMENT STRATEGIES THAT USE SHORTING
Conditions in the stock market can vary. Short selling can be a useful tool to broaden an investor’s opportunity set and decrease
portfolio volatility. There are three primary strategies that utilize short selling. Market exposure and the percentage of long and
short assets are the primary differences between each strategy.
Market Neutral Strategies have equal long and short
positions. These strategies seek to neutralize market risk
with a targeted market exposure (Beta) of 0.
100% Long
100% Short
0% Net
Market Exposure
Long/short Strategies have disproportionate long/short
positions with a long bias. These strategies seek equitylike returns with less risk than the overall market. Market
exposure (Beta) will vary based on market condition.
100% Long
0-100% Short
100-0% Net
Market Exposure
130/30 Strategies have disproportionate long/short
position, typically 130% long and 30% short with a
targeted market exposure (Beta) of 1.0.
130% Long
CONCLUSION
30% Short
100% Net
Market Exposure
For illustrative purposes only.
While the concept of short selling is straightforward, proper implementation of a short selling strategy is not trivial. Because
shorting comes with its own risks and costs, and involves the challenge of identifying attractive short selling opportunities,
investors are best served with a disciplined and skilled manager at the helm.
DEFINITIONS
Net market exposure is the percentage of assets invested in long equity holdings minus the percentage of assets invested in short equity holdings. Beta shows the
volatility of a manager as compared to the volatility of the benchmark, specifically, the performance that the stock, fund, or portfolio has experienced in a given period of
time as the index moved 1% up or down. A beta above 1 is more volatile than the index, while a beta below 1 is less volatile.
RISKS
Investing involves risk. Some investments are riskier than others. Equities and equity-related securities values will fluctuate, and shares, when sold, may be worth more or
less than the original cost. Small- and mid-cap securities may be subject to more erratic market movements than large-cap stocks, which may go in and out of favor based
on market and economic conditions. The Fund may engage substantially in short sales (borrowing securities), which may prevent it from implementing its investment
strategy to the extent the Fund is obligated to cover a short position at a higher price, resulting in a loss. Because the Fund’s loss on a short sale arises from increases in
the value of the security sold short, such loss is theoretically unlimited. Diversification does not assure a profit or protect against loss in declining markets. The comments,
opinions, and estimates contained herein are based on and/or derived from publicly available information. Past performance is not a guarantee of future results.
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These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing your
retirement savings. In providing these materials Prudential Investments is not acting as your fiduciary as defined by the Department of Labor.
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0302451-00002-00 PI4648 Expiration: 9/30/2018