Short Selling: Meaning, Pros And Cons & Examples

Introduction to Short Selling

Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money. Short-sellers bet on, and profit from, a drop in a security’s price. This can be contrasted with long investors who want the price to go up. Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.

Short selling is strategy designed to profit from the price of market traded security going down, rather than up. Many investors are confused by the concept of short selling, but it’s essential working is the same as for any stock trade- the trader profits when his selling price is higher than his buying price. It offers the advantage of leveraged trading- the ability to generate a profit with a smaller investment- but carries higher risk and higher trading costs than regular buy and sell stock trading.

What is short-selling, and how does it work?

Short selling is a technique traders use to bet against a stock’s price. The process begins with the investor borrowing shares from a broker and immediately selling them at the current market price. The investor expects the stock price to decline, enabling them to repurchase the shares at a lower price. Finally, the borrowed shares are returned to the broker, and the investor pockets the difference between the selling and repurchasing prices.

Example of Short Selling-

Imagine a trader who believes that ABC stock—currently trading at Rs. 50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to Rs. 40. The trader decides to close the short position and buys 100 shares for Rs. 40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is Rs. 1,000: (Rs. 50 – Rs. 40 = Rs. 10 x 100 shares = Rs. 1,000).

When short-selling makes sense-

At first glance, you might think that short-selling would be just as common as owning stock. However, relatively few investors use the short-selling strategy.

One reason for that is general market behavior. Most investors own stocks, funds, and other investments that they want to see rise in value. The stock market can fluctuate dramatically over short time periods, but over the long term it has a clear upward bias. For long-term investors, owning stocks has been a much better bet than short-selling the entire stock market. Shorting, if used at all, is best suited as a short-term profit strategy. 

Sometimes, you’ll find an investment that you’re convinced will drop in the short term. In those cases, short-selling can be a way to profit from the misfortunes that a company is experiencing. Even though short-selling is more complicated than simply going out and buying a stock, it can allow you to make money when others are seeing their investment portfolios shrink. 

Differences Between Regular Investing and Short Selling

While traditional investing involves buying stocks with the expectation of price appreciation and short-selling profits from falling prices, regular investing focuses on selecting undervalued stocks with growth potential. In contrast, short selling seeks out overvalued stocks expected to decline. In traditional investing, the investor holds onto the stocks for the long term, aiming to benefit from capital gains and dividends. On the other hand, short selling involves temporarily borrowing stocks and having a temporary position, seeking to profit from price declines.

When is short-selling profitable?

Short selling can be profitable when executed correctly in a declining market. Traders with a deep understanding of market trends and a keen eye for identifying overvalued stocks stand to profit from short selling. Additionally, short selling can be a hedging strategy for long-term investors to protect their portfolios against market downturns. By establishing short positions in certain stocks, investors can offset potential losses from their long positions.

When Does Short Selling Result in Losses?

Short selling can result in losses when the stock price moves against the investor’s prediction. If the borrowed shares’ price rises instead of falling, the investor must repurchase them at a higher price, resulting in a loss. Additionally, short selling carries unlimited risk since there is no limit to how high a stock’s price can rise. If the stock price climbs significantly, the investor may face substantial losses.

What are the short-selling metrics?

To assess the potential profitability of short selling, traders use various metrics. Some standard metrics include:

• Short Interest: This metric measures the number of short shares investors sell. A high short interest rate indicates bearish sentiment toward a stock.
• Days to Cover: It represents the number of days it would take for all short positions to be covered based on average daily trading volume. A high number suggests significant time is required to close out short positions.
• Short Ratio: Calculated by dividing the short interest by the average daily trading volume, the quick ratio helps gauge the intensity of short-selling activity.
• Utilization Rate: This metric reflects the percentage of available shares borrowed for short selling. A high utilization rate indicates high demand for borrowing, possibly indicating a potential squeeze in the future.

These metrics help traders assess market sentiment, identify potential short-squeeze opportunities, and make informed decisions when selling short.

Pros and Cons of Short Selling

Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.

Pros-

• Possibility of high profits

• Little initial capital required

• Leveraged investments possible

• Hedge against other holdings

Cons-

• Potentially unlimited losses

• Margin account necessary

• Margin interest incurred

• Short squeezes

Cost of Short Selling

Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include: 

Margin Interest

Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.

Dividends and Other Payments

The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.

How to Do Short Selling

To engage in short selling, follow these general steps:

• Select a stock: Identify a stock you believe is overvalued and likely to decline in price.
• Borrow shares: Contact your broker to borrow shares of the selected stock for short selling.
• Sell borrowed shares: Sell the borrowed shares on the market at the current market price.
• Monitor the market: Monitor the stock’s price movements and conditions to determine when to repurchase the shares.
• Buy back shares: Once the stock price declines as anticipated, repurchase the shares at a lower price.
• Return borrowed shares: Return the borrowed shares to the broker, closing out the short position.
• Calculate profit or loss: Calculate your profit or loss by subtracting transaction costs and fees from the difference between the selling and repurchasing prices.

Remember, short selling involves risks, so it is essential to carefully assess market conditions and develop a well-thought-out strategy before engaging in this investment practice.