Short Selling

Short Selling

Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money. Short-sellers bet on, and profit from, a drop in a security’s price. This can be contrasted with long investors who want the price to go up. Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.

Short selling is strategy designed to profit from the price of market traded security going down, rather than up. Many investors are confused by the concept of short selling, but it’s essential working is the same as for any stock trade- the trader profits when his selling price is higher than his buying price. It offers the advantage of leveraged trading- the ability to generate a profit with a smaller investment- but carries higher risk and higher trading costs than regular buy and sell stock trading.

Example of Short Selling-

Imagine a trader who believes that ABC stock—currently trading at Rs. 50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to Rs. 40. The trader decides to close the short position and buys 100 shares for Rs. 40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is Rs. 1,000: (Rs. 50 – Rs. 40 = Rs. 10 x 100 shares = Rs. 1,000).

When short-selling makes sense-

At first glance, you might think that short-selling would be just as common as owning stock. However, relatively few investors use the short-selling strategy.

One reason for that is general market behavior. Most investors own stocks, funds, and other investments that they want to see rise in value. The stock market can fluctuate dramatically over short time periods, but over the long term it has a clear upward bias. For long-term investors, owning stocks has been a much better bet than short-selling the entire stock market. Shorting, if used at all, is best suited as a short-term profit strategy. 

Sometimes, you’ll find an investment that you’re convinced will drop in the short term. In those cases, short-selling can be a way to profit from the misfortunes that a company is experiencing. Even though short-selling is more complicated than simply going out and buying a stock, it can allow you to make money when others are seeing their investment portfolios shrink. 

Pros and Cons of Short Selling

Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.

Pros-

• Possibility of high profits

• Little initial capital required

• Leveraged investments possible

• Hedge against other holdings

Cons-

• Potentially unlimited losses

• Margin account necessary

• Margin interest incurred

• Short squeezes

Cost of Short Selling

Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include: 

Margin Interest

Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.

Dividends and Other Payments

The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.