Short Selling – A Beginner’s Guide To Short Selling

Short Selling is used in the stock market to make a quick sale and to earn a decent profit in a short time. Long-term investors buy stocks and hope to rise in the future, while short-sellers measure the price situation and profit from falling prices.
There are two primary reasons why investors would be involved in short-selling of shares:
1. Speculation – The investor may be speculating the prices of a particular company’s stock to fall due to an impending earnings announcement or several other significant factors.
In this case, the investor buys the shares and sells them at a higher price and then when the price falls, the investor repurchases them at the lower price and returns them to the lender and books profits due to the price difference.
2. Hedging Risk – Another primary reason for short Selling is that an investor holds a long position in some related security. To protect himself from the downside risk, he short sells the same security to hedge the risk.

Advantages

• Provides liquidity to the market, which may reduce stock prices, improve bid-ask spreads and assist in price discovery.
• Ability to hedge an existing portfolio’s long-only exposure and reduce the overall market exposure.
• Short Selling helps the manager use capital proceeds to overweight the portfolio’s long-only component.
• Exposure to both short and long positions can minimize a portfolio’s overall volatility and the ability to add meaningful risk-adjusted returns.

Disadvantages

• Shorting stocks is considered highly volatile, while t’s possible for a stock to fluctuate and go to zero, but this will be seen in a rare case. Stock prices tend to revert, and this turnaround can be quick and significant on the back of some events.
• Borrowing stock can be difficult if the amount of available stock in the market is limited or less liquid names.
• Less liquid stocks can be expensive to buy, and the exchange may limit or ban short Selling during volatile market conditions.
• Short sellers run the risk of borrowed stock recalled by their broker when the short seller has limited control over the price of covering their position.
• While the maximum potential for shorting a stock is 1x, a stock price should be appreciated as there is no limit to the potential losses.
• Short squeezes, where rapid and high upward price fluctuates cause short sellers to cover in mass, can push prices against short-sellers.

Apart from the risk of losing money from shorty selling, let’s look at some of the major risks of short selling:

• Making a mistake in timing

The exercise of conducting short-selling depends on the proper timing of buying and selling the shares. However, the stock prices may not immediately fall, and while a trader is waiting to book a profit from stock price, he is liable to pay interest and margin.

• Borrowing money

Short selling is known as margin trading, in which a trader borrows money from a brokerage by using an asset called collateral. The brokerage firm made it compulsory for all traders to maintain a certain percentage in the account.
If a trader falls short at any point, they will be asked to meet the shortfall.

• Selecting wisely

Several companies go through ups and downs but overcome them deftly. Wise administration can transform the course of a company by increasing its share price instead of decreasing its value.
However, If a trader chooses the wrong company to bet on, they may lose profit in short selling when others gain by taking a long position.

• Returning Security

The primary duty of the seller must be to return the security to the owner within the stipulated period falling which the seller will be subjected to scrutiny by the market regulator.

• Regulations

Although market regulators permitted short selling, they can face a ban in a specific sector at any time to safeguard and to avoid panic, which can lead to a rise in prices.

• Betting against the trend

The stock prices generally fluctuate up and down in the long run. Short selling depends on prices moving down, which is going against the drift.

• What is Short Selling in the Stock Market?

Short Selling is used in the stock market to make a quick sale and to earn a decent profit in a short time. Long-term investors buy stocks and hope to rise in the future, while short-sellers measure the price situation and profit from falling prices.

• Why is short selling also known as margin trading?

Short selling is known as margin trading, in which a trader borrows money from a brokerage by using an asset called collateral. The brokerage firm made it compulsory for all traders to maintain a certain percentage in the account.

• What is the major advantage of short-selling?

Provides liquidity to the market, which may reduce stock prices, improve bid-ask spreads and assist in price discovery.

Final Thoughts

Short selling is not considered for inexperienced traders and speculators unaware of the significant risk and potential losses involved in this activity.
Only those traders who have in-depth knowledge about short selling and market dynamics can conduct short selling to book significant profits.