What is short selling?
Short selling is selling an underlying security first which the Short seller doesn’t own.The short seller has to borrow the security from a broker.
The Short seller bets that the price of the underlying security will drop.As the old rule in stock market ‘Buy low and sell high’ ,this trading technique is totally the same, sell high and buy low.Only the direction of the trade changes.
Risks Involved in short selling
There are major risks involved in short selling.These risks should be kept in mind before anyone should jump into short selling.
- Although trading is always risky, there is an additional amount of risk in short selling.In theory, when we take a long position or we buy stocks, the maximum risk that we have is the amount of money that we spend to buy the stock.Our profit potential is unlimited.
- But in selling short our profit potential is limited to the price of the stock.Our risk is unlimited as the price of the stock can increase to any levels.So cutting losses very quickly is very important in short selling as we might face big losses in the game of short selling.
- The security is borrowed from the broker.In turn, the broker might borrow the stock from another brokerage firm ,another customer or a fund.But when a stock is in high demand or if the lender asks the stock back, the broker has to cover your sort selling position at the prevailing rates.The broker might ask you to do so, or it may do it without even taking your permission.If the price of the stock is higher than your selling price at prevailing rates, you might face losses without any fault of yours.
- If the stock promoter declares dividend during the course of your short sell, you must pay the dividend to the stock lender.Similarly, if the stock promoter splits the stock during the course of the Short sell, you owe double the number of stocks to the lender at half the price of the stock.
- The broker takes a percentage for lending the stocks to the Short seller.This percentage can be significant when the stock is not available due to heavy short positions(heavy short interest).In this time of hard to borrow situation, the charges for lending the stock can be huge, leading to a dent in the pocket of the Short seller.
- The Short positions of a stock can be measured by two metrics.These are short interest and short interest ratio.Short interest can be found by finding out the percentage of short stocks to the total number of outstanding stocks.Short interest ratio is found by dividing the number of shorted stocks by the average trading volume of the stock.If these numbers are high, then there is a possibility of a short squeeze.
- A short squeeze happens when there are heavily shorted positions in the stock.If there is a sudden positive development in the company or the broker has to close the trade due to lenders asking their stock back, there may be a huge spike in the stock price due to short covering.This kind of unexpected spike in price lead to short selling a risky business.
- Sometimes the regulator can ban short selling on a stock due to panic selling.This might lead to a spike in the stock prices.The short seller has to cover his position at huge losses due to such unexpected events.
Now that you understood the risks of short selling , let us understand how you can profit from short selling.
For short selling, you require opening a margin account.Some people confuse margin with leverage.Leverage is loan taken from the broker to trade.Leverage should be taken with caution as there may be huge losses arising from the unsuccessful use of leverage.The losses can exceed the investments.I will not suggest to use ‘all in’ strategy even.That is using all your money on a single trade, gone is the case of leverage.
A margin account is required because the shorted stocks are not owned by you.The money in your trading account or your stock holdings in your trading account acts as collateral for your shorted positions.Suppose you end up with heavy losses in short selling and you do not have excess money in your trading account to pay for your losses, the broker has right to liquidate your existing positions in order to pay for the losses.
This is not possible in case of a cash account.So a margin account is a necessity for short selling of stocks.
Most of us have seen the movie The Big Short in which Michael Burry a hedge fund manager and a doctor by profession bets against the housing market by purchasing Credit Default Swaps from investment banks and eventually turns out to be right and makes profits of 489% by betting 1 billion dollars on it.This was based on a true story.
The most famous short selling bet was by Gorge Soros.He short sold US $ 10billion worth of pound to profit US $1billion on a single day in 1992.He is famously known as ‘The man who broke Bank of England’.Other notable shorts are listed below:
Gorge Soros quote:The hardest thing to judge is what level of risk is safe.
So how can you profit from short selling?
Suppose you came to XYZ stock trading at Rs. or $ 100 a share.You know that the price of the stock will fall to Rs. or $90 a share.You shorted 100 stocks of XYZ company at Rs. or $100.The stock is borrowed from the broker.The money made after selling 100 stocks of XYZ at Rs. or $ 100 is 10000.This amount of money is credited to your account.
Now when the price of the stock becomes Rs. or $90 , you buy 100 stocks back of XYZ company.You pay a price of 100*90=9000.The difference between selling and buying price is your profit.Here it is Rs. or $ 1000 excluding your fee to be paid to the broker.
So now the most important question that arises is when you will short sell?
Most successful short sellers use fundamental and technical analysis to short sell.Many use a combination of both.
Some techniques such as scrutinizing the balance sheet and finding out wrong doings of the company or dismal future of the company in future are employed by the successful short seller.Others use technical analysis.
One thing is to be noted that never short share stocks in the bull market.This is because the prices of the stock may keep on rising irrationally.This may be longer than your ability to remain solvent.
If the market is overpriced, it may continue to get even more overpriced in a bull market before ultimately it will go crashing.It will be very hard to remain solvent, although even you may be right.
This is very clear from the movie The Big Short where Dr.Michael Burry faced difficulties in remaining solvent and had to close all fund withdrawals from his hedge fund.Dr.Michael Burry was primarily an investor.Investors shorting the market is a rare phenomenon.
So it should be clear that shorting stock is a very difficult ball game.Even if you are right, you need tremendous conviction and gambling attitude to short big positions for a longer duration.
Some practical tips:
- Short markets when a bad event has just taken place.Don’t try to short when the bad event has already priced in and had gone to oversold zone.This is because you might get trapped in a short squeeze.
- Shorted shares should be brought back when the trade is profitable.Do not wait too long for more profits as the market may bounce back anytime.
- Investors should never be selling shares in a bear market.They should rely on purchasing put options.But retail investors can book half of their profits at the start of a bear market.Investors should not try markets shorting in the bear market without learning the applicable skills.