Hedge Fund Management: A New Respectability for Short Selling (2024)

FAQs

Do hedge funds engage in short selling? ›

Hedge funds are one of the most active entities involved in shorting activity. Most hedge funds try to hedge market risk by selling short stocks or sectors that they consider overvalued.

Hedge fund managers typically earn above-average compensation, often from a two-and-twenty fee structure. Hedge fund managers typically specialize in a particular investment strategy that they then use to power their fund portfolio's mandate for profits.

Short-selling gives traders a whole new dimension of market movements to speculate on – as traders can make money even if the underlying asset drops in price. Hedging is another way to use short-selling. With hedging, traders can protect against losses to a long position.

Losses for short-sellers can be particularly heavy during a short-squeeze, which is when a heavily shorted stock unexpectedly rises in value, triggering a cascade of further price increases as more and more short-sellers are forced to buy the stock to close out their positions.

The SEC's October short-selling rule requires hedge funds to report short positions to the regulator, which publishes them with a delay on an aggregate basis in which individual traders remain anonymous.

There may be heavy losses, difficulty in timing the market, and a need for a margin account. These are the common disadvantages of short selling.

It is possible to hedge a short stock position by buying a call option. Hedging a short position with options limits losses. This strategy has some drawbacks, including losses due to time decay.

Short selling a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall shortly after. If it does, the trader can buy the shares back at the lower price, return them to the broker, and keep the difference, minus any loan interest, as profit.

What is the problem with short selling? ›

The risk comes because there is no ceiling for a stock's price. Also, while the stocks were held, the trader had to fund the margin account. When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if many other traders are shorting the stock or the stock is thinly traded.

With a long position, the share price can only fall from its current level to zero, hence the maximum potential loss is theoretically limited to 100%. With a short position, the share price can continue to rise in a (seemingly) infinite path, creating losses significantly greater than 100% for short investors.

Long-short equity is commonly used by hedge funds, which often take a relative long bias—for instance, a 130/30 strategy where long exposure is 130% of AUM and 30% is short exposure.

Under the law, funds must hold assets for more than three years for gains to be considered long-term. 6 Any gains held for less than three years are considered to be short-term, and are taxed at a rate of 40.8%. 7 But this change rarely applies to most hedge funds, which generally hold assets for more than five years.

Hedge Funds

While many financial institutions are prohibited from trading penny stocks, loosely regulated hedge funds have no such restrictions. That said, most hedge funds won't trade penny stocks on the long side: They far prefer short-selling penny stocks that look to have peaked after being heavily promoted.

It is possible to hedge a short stock position by buying a call option. Hedging a short position with options limits losses. This strategy has some drawbacks, including losses due to time decay.