Short selling is a trading stance based on the assumption that the stock is going to decline in value. Having said that, if you think it is easy money, stop right there. In the market, there is no easy money.
How it works.
If you believe a stock’s value will increase over time, you want to buy it and hold it, which is known as taking a long position.
But if you believe that a stock’s price will decrease, you take a short position. To do this, you would borrow shares of the stock and sell them to another investor (even though you don’t own the shares yet).
Let’s say you borrow 1,000 shares of Company A and sell them at a price of Rs 45 per share. You make Rs 45,000. But you owe the broker 1,000 shares. Now if the share price drops to Rs 35 per share, you can close the position by buying 1,000 shares at Rs 35. You can now return the 1,000 borrowed shares to the broker. So you bought 1,000 shares at Rs 35,000, but you had sold them at Rs 45,000. Neat profit!
Short selling is one way for investors to attempt to profit from a stock’s price going down instead of up. But is that guaranteed? Of course not. Nothing in the stock market is guaranteed.
If the stock’s price keeps rising, the short seller will be in a soup. Because he will have to repay the borrowed shares at a higher price than what he sold the shares for.
Let’s revisit Company A. You sold 1,000 shares for Rs 45 per share. But contrary to what you anticipated, the stock price keeps increasing. You keep waiting in hope that the price trend will reverse. Finally, you end up buying the shares at a Rs 50 per share. So you sold it for Rs 45,000 but paid Rs 50,000 to acquire it.
The danger.
When you buy a stock as an investment, the most you can lose is the amount of capital you invested. Let’s say you bought the 1,000 shares of Company A to hold on to for a few years. If you bought it at Rs 45 a share, your investment would be Rs 45,000. Even if the stock price drops, you can wait for years for the stock price to start picking up. Should the investment turn completely worthless, the most you can lose is Rs 45,000. So even in the worst-case, though highly improbably, scenario, the loss is capped at Rs 45,000.
With a long position, an investor’s potential gains are unlimited while the loss is capped to 100% of what is invested.
Back to shorting. You shorted 1,000 shares at Rs 45 a share. Now the stock price keeps rising. Imagine if that stock price shoots up to Rs 500 per share. You will end up purchasing 1,000 shares at a cost of Rs 5 lakh. Stock prices can (in theory) rise indefinitely. So short selling can lead to potentially unlimited losses. But the stock price cannot drop to less than zero. So the potential gains are limited.
Remember George Soros’ words: It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.
It may sound pretty straightforward, but the short seller needs to narrow down on the right stocks.
In The Art of Short Selling, author Kathryn Staley lists three categories.
- Companies in which management lies to investors and obscures events that will affect earnings.
- Companies that have tremendously inflated stock prices - prices that suggest a speculative bubble in company valuation.
- Companies that will be affected in a significant way by changing external events.
Short selling, or shorting, is not a scam. It is perfectly legal.
In Street Smarts, author Jim Rogers explains why short sellers are needed.
Most people buy a stock at, say 10, and sell it at, say, 25. They buy and sell to make a profit. Selling short reverses the process by which a profit is made. You sell the stock at 25 and buy it at 10. How do you sell it if you do not first have it? You borrow the stock from a broker. So I borrow 100 shares and sell it at 25, the current market price. When it goes to 10, I buy 100 shares and return it to the broker.
Short selling is indispensable to the market. It adds liquidity as well as stability. The market needs buyers and sellers. Without sellers, prices can skyrocket. Without buyers, prices collapse.
Suppose everybody, caught up in the dot-com mania, wants to buy a stock like Cisco. The stock goes from 20 to 80. The short sellers start coming in. The stock might then go to 90. Without short sellers it would go to 110. Without short sellers, there would be no sellers at all - there would be no liquidity, things would go nuts. Short sellers temper the mania.
Suppose the short sellers are right and the stock starts heading toward a collapse. Everyone is in panic, begging to get out. But with the stock crashing, there are no buyers. The short sellers have to buy back the stock. They have to cover their shorts. So in the collapse, the stock does not drop as much as it might have.
Short sellers are good for the market.
Recap
- Short sellers act with conventional wisdom – they buy low and sell high, but they sell before they buy.
- Most investors approach the market to look for the best stock to buy. A short seller will approach the market to look for the best stock to sell.
- The idea behind shorting a stock is to profit from a drop in the price of a stock.
- The trader must identify overpriced stocks that are likely to decline. And then identify the proper entry and exit prices.
- Short sellers fear a sustained rally in the stock they shorted followed by a forced buy-in of their position, resulting in a significant loss.
- Since the stock price can rise exponentially, the loss for a short seller is not capped at all. The risk is technically unlimited.
A word of advice: Steer clear. If you want to, first understand the basics of trading, and then trade with an amount you can afford to lose.
