The entire business ecosystem is going through post-correction mode right now which is causing panic amongst even the most seasoned investors. One strategy, though quite infamous, actually rolls the buck is short-selling. But what exactly is it? To understand this, we need to dive deep into the spectrum of the unknown.
Definition:- What is short selling?
Short selling occurs when an investor sells all stocks that they do not own at the time of a trade. In short, a trader, with the help of brokers, buys shares from the owner and sells them at the current market price in the hope that prices will rise.
When the stock price falls, the seller buys the stock and makes a profit. However, short selling carries a high risk/reward ratio and traders can make profits or incur heavy losses from short selling.
Why do investors prefer short selling of stocks?
Short selling is used in the stock market to make a quick sale and make a decent profit in a short amount of time. Long-term investors buy stocks expecting them to rise in the future, while short-sellers gauge price trends and take advantage of falling prices.
There are two main reasons investors engage in short selling of stocks:
1. Speculation – The investor may speculate that a particular company’s share price will fall due to an upcoming earnings announcement or other important factors. In this case, the investor buys the shares and sells them at a higher price and then when the price falls, buys them back at the lower price and returns them to the lender and makes a profit on the price difference.
2. Hedging Risk – Another major reason for short selling is that an investor goes long in a related security. To protect against downside risk, he shorts the same security to hedge the risk.
To short a stock, a trader opens a position by borrowing shares from a broker before immediately selling that position to other buyers in the market.
To close the trade, the short seller ideally needs to buy back the stock at a lower price to repay the amount borrowed from the broker. If the stock price has fallen as the trader expected, the trader receives the difference in price minus fees and interest as profit.
Selling short, as this strategy is sometimes called, is a way for traders to bet on falling prices or to cover a position. While it may seem simple, short selling involves many risks. If a stock’s price goes up instead of down, the short seller loses money, and that doesn’t even include the fees for borrowing the stock that is part of this trading strategy.
Why short selling?
The main benefit of short selling is that it increases the number of trading opportunities. The two most popular reasons for short selling are speculation and hedging.
Short selling offers traders a whole new dimension of market movements to speculate on as traders can make money even if the underlying asset falls in price. Hedging is another way to use short selling. Hedging allows traders to protect themselves from losses on a long position. For example, if a trader is long the S&P 500, a move lower could have a negative impact on the trader. Therefore, traders also open a short position to mitigate the impact.
But short selling also has its downsides. There is a greater risk of loss if the price of the asset does not behave as expected. If the price of an asset goes up, the trader’s losses could be unlimited. And when that happens, a short crunch can occur, meaning all the short sellers try to cover their positions at once, pushing the stock price even higher and amplifying losses. Therefore, it is important to have a risk management strategy.
Risks of short selling
Aside from the risk of losing money selling short, let’s take a look at some of the main risks of short selling:
Making a Mistake in Timing
Executing short-selling depends on the right timing for buying and selling the stock. However, stock prices may not fall immediately, and while a trader expects to make a profit on the stock price, they are responsible for paying interest and margin.
Short selling of stocks is known as margin trading, where a trader borrows money from a brokerage house using an asset called collateral. The brokerage firm made it compulsory for all traders to keep a certain percentage in the account.
If at any time a trader is in deficit, he must cover the deficit.
Return of the guarantee
The primary obligation of the seller must be to return the guarantee to the owner within the stipulated period within which the seller is subject to inspection by the market regulator.
Although market regulators have allowed short selling, they may at any time face a ban in a particular sector to protect themselves from the panic that could lead to price increases.
Bet Against the Trend
Stock prices generally go up and down over the long term. Shorting depends on falling prices, which goes against the grain.
Example of short selling for profit
Kamala plans to short a $5,000 bitcoin, meaning she borrows it from a broker and sells it at the current market value.
Once the price drops to $2000, she buys a Bitcoin at a lower price and returns it to the broker along with the interest due. The difference between the selling price and the buying price of bitcoin ($5,000 – $2,000 = $3,000) becomes Kamala’s profit. She must pay the interest applicable to the crypto on what she has left.
Example of short selling for a loss
If we take the same situation mentioned above, then if the price of bitcoin goes up to $10,000 then she incurs a loss along with the extra amount of regulatory and brokerage tax and fee she has to pay. The loss she will cough up would be ($5,000 – $10,000 = -$5000).
Example of short selling for hedge
The primary purpose of hedging is protection, as opposed to speculation for pure profit. Hedging is done to protect gains or mitigate losses in a portfolio, but as it involves significant costs it is not considered by the vast majority of retail investors.
There are two main costs. There is the actual cost of hedging. Costs related to short sales or premiums paid for hedging option contracts. In addition, there is the opportunity cost of limiting the portfolio’s upside if markets continue to move higher. As an example, if 50% of a portfolio that is closely correlated to the BSE 50 Index is hedged and the index rises 10% over the next 12 months, the portfolio would do about half as much at this profit or 5%.
Pros and cons of short selling of stocks
➢ Provides liquidity to the market, which can drive down stock prices, improve bid-ask spreads, and aid in price discovery.
➢ Ability to hedge an existing portfolio’s long-only exposure and reduce overall market exposure.
➢ Short selling helps the manager use the capital proceeds to overweight the long component of the portfolio.
➢ Exposure to both long and short positions can minimize a portfolio’s overall volatility and the opportunity to add significant risk-adjusted returns.
➢ Short selling stocks is considered highly volatile as it is possible for a stock to fluctuate and go to zero, but this will happen on rare occasions. Stock prices tend to reverse and this change can be rapid and significant due to some events.
➢ Securities lending can be difficult when the number of stocks available in the market is limited or names are less liquid.
➢ Buying less liquid stocks can be expensive, and the stock market may restrict or prohibit short selling during volatile market conditions.
➢ Short sellers run the risk of their broker withdrawing shares they have borrowed if the short seller has limited control over the hedge price of their position.
➢ While a stock’s maximum short-selling potential is 1x, a stock’s price should rise as there is no limit to potential losses. Short crunches, where high and rapid price moves cause short sellers to cover en masse, can push prices against short sellers.
How to short a stack
Set up a margin account with the broker
Short selling requires the use of a margin account, which allows the trader to borrow money to buy securities. Before the trader can start trading on margin, he must meet the minimum requirements set by the Financial Industry Regulatory Authority, also known as FINRA. It should be noted that federal law generally requires short sellers to have an initial balance in the margin account equal to 150% of the value of the shorted shares, with an upkeep requirement generally being 30%.
Search for short sale stocks
Once the trader has clearance from the broker to short a stock, he needs to identify an opportunity by researching the stock. And because of the downside potential, it’s very important to present a solid thesis as to why the stock price will decline, and one that’s based on a thorough analysis of the company and its stock.
Make a short sale plan
Before engaging in any aspect of trading, the trader should make a plan to enter the trade and, more importantly, exit the trade at a profit, taking into account fees and interest charged on the amount borrowed. Since short selling is based on the idea that prices will fall, he should also have a contingency plan in place to minimize losses should the stock price rise.
Carry out the short sale
Once the above steps are complete, it’s time to put money behind the bet. Using stop orders for trades can make it easier to execute the trade as planned without letting emotions sway the decisions.
Short selling at any given point in time is extremely bold and dangerous. But that’s where the right skill and knowledge come to play. With the right perspective and timing, short selling for stocks can yield a fortune. It is as the old saying goes- “The big risks bring the big rewards.”
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