I’ve been asked many times about my opinion on short selling, here it is…
What is Short Selling?
Shorting is simply a way to make money when you expect the price of a stock to go down.
How Does Short Selling Work?
Let’s say the price of XYZ stock is $100/share
I think the price of XYZ stock is going to go down to $50.
I want to make money off of this knowledge.
So I go to a broker and I ask: “hey, can I borrow shares of XYZ stock from you?”
The broker says: “Sure, you can borrow them if you pay me a fee and you promise to return the shares.”
So I take the shares I borrowed from the broker and I sell them for their current market price of $100/share.
If the price of the shares falls to $50/share or some other number less than $100/share, I can repurchase the shares and the difference between the price I got when I sold them for $100 and the cash I used to buy them for less than $100 is my profit.
Put differently, instead of the standard investing approach of attempting to buy low and sell high, the short seller is attempting to sell high and buy low.
Important Points About Short Selling
Risk vs. Return in Short Selling
The most a short-seller can make is the price of the stock when they sold it.
Going back to our example of XYZ stock, the most the short seller can make is $100/share if the price of XYZ goes to $0.
The most a short-seller can lose is technically infinity since the price of a stock can go up indefinitely.
Recall that the short seller will eventually have to buy back the stock and if the price of the stock has gone up, the short seller will incur a loss equal to the amount of price appreciation the stock experienced.
Short sellers are required to keep some money in their accounts as collateral. This is called a margin. Typically, margin requirements are around 50% of the borrowed stocks current market price.
So if a short seller wanted to borrow 1 share of XYZ when it was selling for $100 to sell short they would have to post $50 in their margin account as collateral.
If the price of XYZ goes up, let’s say to 150$, the short seller is going to get a margin call since the amount of his collateral is now below the required level (maintenance margin is typically around 35%).
In the case of receiving a margin call, the short seller can either add more cash to their margin account, or they have to cover their position and basically buy back the stock they borrowed at a loss and return the shares to the broker.
Short Selling Causes Prices to Overshoot
Short selling causes the prices of shorted stocks to overshoot when they go up and overshoot when they go down.
This is because when a stock goes up in price, more and more short sellers get margin calls which forces these short sellers to buy shares in order to cover their positions which creates artificial demand for the stock which in turn drives the price up even further.
On the other hand, when the price of a stock is going down, short sellers have a tendency to short the stock even more which means they will borrow shares from people who don’t necessarily want to sell and sell these shares creating artificial supply which drives the price down even further.
This is the reason why the SEC temporarily banned short selling on around 1,000 financial institutions during the financial crisis of 2008.
Short Selling: Halal or Haram?
Most commentators on this topic are in agreement that short selling is Haram. The most commonly cited reasons are the following:
1- You are not allowed to sell something you’ve borrowed.
Hakim ibn Hizam (Radiyallahu ‘Anhu) narrates that he said, “O Prophet of Allah, a person asked me to sell him something which I do not possess, may I sell it to him?” the Prophet of Allah replied, “Do not sell that which you do not possess.”
Many commentators on this hadith have interpreted it to mean that you are not allowed to sell that which you do not have ownership of.
Since short selling involves selling borrowed shares it is therefore Haram.
2. The fee the broker charges for letting the short seller borrow shares is Riba.
Rather than provide my commentary on the previous two objections I will focus on what I think is the stronger argument that cannot be denied about Short Selling which is that:
3. Short Selling is a form of Al-Maisir [Gambling].
Al-Maisir which is strictly prohibited in Islam.
“O you who believe, intoxicants, Maysir, sacrificing for idols and making decisions based on games of chance are sicknesses from the work of Satan, so avoid these things so you may prosper. Satan desires to create enmity and hatred amongst you through intoxicants and Maysir and to stop you from praying and remembering Allah. So will you abstain from these things?”English Translation of Quran 5:90-91
As I pointed out in previous videos/articles Maisir involves the creation of risk in hopes of making money without any corresponding value creation or even the prospects for creating value that can justify the risk being created.
In the case of buying and selling a stock, no risk is being created.
E.g. Adam sold a stock to Fatima, so the risk of stock ownership was transferred from Adam to Fatima. The overall level of risk in the market is unchanged.
However, when a stock is shorted, additional risk is being introduced into the market without any corresponding value creation that can justify the risk that is being created.
E.g. Bob borrows stock from Adam and then sells the stock to Kareem.
In this case Bob, Adam and Kareem all assume the stock’s price risk.
Adam and Kareem both own the same share of stock (which was made possible by the fact that Bob sold something he borrowed).
Additionally, Bob has unlimited risk represented in the prospect that the shares he borrowed and sold appreciate in price.
This is the definition of the worse type of prohibited Maisir in Islam.
As a result, it is my opinion that short selling is absolutely Haram. [prohibited in Islam]
There are simply no value creating prospects from engaging in the act of shortselling that can possibly justify the risk that is being created.
Frankly, I think shorting creates negative value in the financial markets by causing prices to overshoot their justified levels.
…and Allah knows best.