Short selling is an investment strategy that operates on the principle of “buying low and selling high”. As an investment strategy, short selling speculates on the decline in stock or other securities prices.
Short selling is the practice where the investor sells the share not owned by him to make quick profits. To put it in simple words, short selling involves the selling of a security that the seller has borrowed with the promise to buy back the shares later.
Short selling also referred to as shorting, is the process where the trader sells the securities or stocks at the prevailing market rate. This is done to shorting the position. The trader then waits for the prices to fall and thus buys the stocks or securities at a reduced price to close such a position.
Short selling is used by traders for speculating, whereas investors and portfolio managers use short selling as a hedge against a downside risk of a long position. Speculation carries a higher substantial risk and is referred to as an advanced trading method. On the other hand, hedging is a more common transaction that involves offset position setting to reduce the risk involved.
Short selling can be carried out via a stockbroker, but since it involves the borrowing of shares, you’ll hardly find a broker who is willing to lend you shares to sell. Thus, short selling via a stockbroker is a complicated process. Hence, derivatives products such as CFDs are becoming a popular method of short selling.
When does short selling results in a loss?
Gains from short selling are realized only when the prices of the stock’s decline and when the seller buys them back at a lower market price.
Since short selling is based on predicting a decline in the future prices of the stocks, it results in losses if the decline is wrongly predicted. Traders, in such a scenario, stand a chance to suffer infinite losses. The term ‘infinite losses’ is used in short selling only when the modus operandi is “buy low, sell high”.
Under conventional trading, a trader buys shares for a specific price and expects the prices to rise in future when they can be sold to earn a profit. In such a case, even if the prices fall, the losses faced by the traders are limited to the extent of their investment. Thus, it involves limited risk. However, in case of short selling, if contrary to the decline in share prices they surge, it can then skyrocket infinitely hence posing an unlimited risk.
The high level of risk involved in short selling is what refrains long-term investors from indulging in it.
What are the Pros and Cons of Short Selling?
Short selling comes with its own set of advantages and disadvantages which a trader should be aware of before taking it up as a practice.
Short Selling Advantages
Following are the advantages offered by short selling:
- There are chances of substantial gains if the predictions of price fall are realized
- Short selling can be used as a hedge against the downside risk either of the securities or to the ones related to it.
- The only investment that is required to be made by the trader includes margin maintenance, commissions, and dividends if any.
- It provides liquidity to the market.
- Traders can make profits even in the bearish markets.
- Short selling helps in the price correction of overvalued stocks.
Short Selling Disadvantages
Following are the consequences or disadvantages of short selling:
- Traders involved in short selling are exposed to infinite risks as compared to the risk involved in conventional trading.
- Since borrowing is involved in short selling, it implies that the trader has to bear the interest on the borrowed stocks and also to maintain a margin.
- Short selling is extremely time-sensitive. If shorting of stocks is done before the price drop the trader might have to bear an extra cost associated with short selling.
- Traders are prone to short squeeze when buying back stocks.
- Short selling is capable of increasing the price volatility of shares.
- Short selling is capable of causing destabilization in the entire market.
Risks of Short Selling
Apart from the disadvantages mentioned above, short selling involves other risks as well, which are as follows:
- Making timing mistake: Short selling depends extremely on the proper timing of selling and buying the shares. The prices of the shares under trade might not decline immediately. While the trader waits to book a profit, he/she is required to pay margin and interest.
- Borrowing money: Short selling in other words also means margin trading wherein the trader borrows money from a broking firm using an asset or collateral. The brokerage firm makes it mandatory for traders to keep a certain percentage in their account. If he/she falls short at any point of time, they’ll be asked to meet the required shortfall.
- Choosing Wisely: Wise administration can change the course of how a company performs, which might increase the company’s share price instead of declining it. Thus, if a trader chooses the wrong company for short selling, the risk of losing increases.
- Returning the Security: The seller is required to return the security to the owner within the stipulated time period. If the trader fails to do so, the seller will be subject to scrutiny by the market regulator.
- Excessive Regulations: Though a lot of market regulators permit short selling, it can face a ban in a particular sector at any point of time to avoid any panic. This can further lead to a surge in prices of the stocks hence increasing the risk for the traders involved in short selling.
Keeping in mind the various advantages and disadvantages of short selling, it can be very well concluded that short selling is not for inexperienced traders and speculators who are not aware of the inherent risks involved in the activity. It is only suitable for those traders who have an in-depth knowledge of the market and has already practiced short selling before.