The traditional approach to trading in the stock market and making a profit out of it is through "buying low and selling high", also known as a long position. It is an approach primarily adopted by investors in a bullish market when prices of stocks are expected to rise.
Contrarily, a short position is adopted in a bearish market when share prices are expected to decline.
What is Short Selling and How Short Selling Works?
Short selling, as opposed to a long position, is an investment strategy with the underlying motive of "buying low and selling high". Investors, who short sell stocks, expect share prices to drop on a future date and aim to capitalize on this prediction.
Since it depends on speculation and entails infinite risk theoretically, only seasoned investors partake in short selling. To short stocks, traders sell shares that they do not own but are instead borrowed from a broker-dealer, thus opening a position. They sell it at the prevailing market rate, thus shorting the position and waiting for prices to drop. Eventually, traders need to buy back those stocks they sold short to close such a position.
If prices do drop, traders make a profit from the difference between the selling price and the purchasing price. However, if such a prediction for price declination does not realise and share prices move upward instead, the concerned trader stands to lose. Apart from speculation, investors and fund managers also use short selling to hedge the downside risk of holding a long position on securities or any related ones.
To sell short, traders need to have a margin account using which they can borrow stocks from a broker-dealer. Traders need to maintain the margin amount in that account to continue keeping a short position. However, a margin account is only applicable when an investor is borrowing stocks from a broker. Margin account does not apply to investors or fund managers who hedge their long position against any downside risk.
Differences Between Regular Investing and Short-selling
Shorting a company has its own set of restrictions that differ from conventional stock investment, including one that prohibits short sellers from driving down the price of a stock that has declined more than 10 percent in one day compared to the previous day's closing price.
Risk of losses on the short sale is theoretically infinite. A stock's price could continue to grow indefinitely. Short selling is best used by experienced traders who understand the dangers.
When is Short Selling Profitable?
Short selling is profitable when a trader speculates correctly, and share prices do fall below the market price at which a trader sold short. In that case, a trader gets to keep the difference between the selling price and purchasing price as profit.
Short selling example – Rahul speculates that the current market price of stock ABC at Rs.200 is way overvalued and expects that once its quarterly financial reports are out in a week, its share price will drop. He borrows 20 ABC stocks and sells them in the market at Rs. 200, thus getting "short" by 20 stocks. In a week, as predicted, the price of ABC stocks starts to fall and reaches Rs. 175. He then repurchases those 20 stocks at the lower rate of Rs. 175, thus pocketing Rs. 25 per share as profit and earning an overall profit of Rs. 5000 (Rs. 25 x 20). He then gives back those stocks to the original broker.
Even though, theoretically, Rahul profits Rs. 5000, in reality, there is interest on the borrowed stocks and commissions that an investor needs to pay. And depending on the timing of selling short, a trader might also need to pay a dividend to its buyer.
Additionally, a stock might be overtly shorted by other traders that might cause a paucity of the stocks available with a broker. In that case, the borrowing costs might be steeper. Also, even after borrowing, there is no certainty that a trader will find buyers and sellers in the subsequent stages.
When Does Short Selling Result in Loss?
When a trader predicts wrongly about the declination of share prices, they stand to lose infinitely. The term "infinite risk" particularly applies to short selling where the modus operandi is "sell high and buy low".
In the conventional trading approach, a trader purchases shares at a specific price and expects it to rise in the future when she can sell it to earn profits. In that case, even if the share prices fall a trader only stands to lose to the extent of her investment, thus limited risk. In case of short selling stocks, if contrary to prediction share prices surge, it can skyrocket infinitely, thus exposing a trader to unlimited risk.
Short selling example – Ruth speculates that PNM stocks will fall in value from its current market price of Rs. 100 when the company announces its dismal annual reports in the next week. Relying on this speculation, she borrows 15 PNM stocks and concludes short selling in the stock market at Rs. 100/share. However, just after the annual report's announcement, the company was overtaken by a reputed conglomerate, thus driving its share prices upwards to Rs. 110. Ruth then decides to close the position and buy back the shares at the increased market rate. She, therefore, realizes a loss of Rs. 10/share, and Rs. 1500 (15 x 10) overall in addition to the interest and commission.
What are the Short Selling Metrics?
Traders primarily resort to two short-selling metrics to determine which stocks are overvalued or are expected to fall in value in the future. These are –
Days to cover ratio
Also known as a short interest to volume ratio, it denotes the relationship between the total numbers of stocks that are held short and its current trading volume in the market. It provides an insight into how well a stock is holding in terms of demand. A high ratio, therefore, indicates a stock's bearish trend.
Short interest ratio
It represents the relationship between the numbers of stocks that are shorted and the numbers of stocks that are currently afloat in the market. A high ratio would indicate a high short interest and a substantial possibility that such stock will fall in price in the future. On the other hand, a high short interest ratio also exacerbates the possibilities of a short squeeze.
What are the Advantages of Short Selling?
The advantages of short selling are mentioned below –
- Probability of substantial gains if the prediction of price fall is realised.
- Margin maintenance, commissions, and dividend, if any, are the sole investments required to execute short selling.
- It can be used as a means to hedge against the downside risks of the securities or the ones related to it.
What are the Disadvantages of Short Selling?
The disadvantages of short selling are –
- Traders indulging in short selling are exposed to infinite risk, as opposed to the contained risk of conventional trading.
- Short trading involves borrowing from a broker, and that implies bearing interest on the borrowed stocks and also maintaining the margin. If the margin is not maintained due to market fluctuation or otherwise, the trader might need to increase funding or liquidate his/her position.
- Short selling is supremely time-sensitive. If a trader shorts stocks long before their price drop, then they might have to bear the costs associated with short selling for a prolonged period. Conversely, if a trader shorts stocks a tad too late, then chances that the stock has lived out most of the price fall are high.
- Traders are also prone to short squeeze when buying back stocks. It typically happens when a stock has a high short interest. In this case, if a stock goes high and short-sellers all start to close their positions, i.e. buy back the stocks, it drives up the share price, causing a short squeeze.
How to Do Short Selling?
To short a stock, you must have margin trading enabled on your account, which allows you to borrow funds. The complete amount of the stock you short will be treated as a margin loan from your account, and you will be charged interest on the loan. As a result, you'll need enough margin capacity, or equity, to back up the loan.
