Investors employ various strategies to generate profits from their investments. Over time, many tools have been developed to reduce losses and attract more traders. Although the traders' tactics or strategies frequently benefit them, they can also backfire in certain circumstances. One such strategy that has gained traction is short selling or shorting. This blog explains shorting definition and what is short selling in the stock market.
What is shorting a stock?
Shorting is a trading strategy that relies on the expectation of a future market crash. The trader opens a position by borrowing shares, and then when it plunges, they sell the shares. With this strategy, investors can purchase the shares at a lower price than the one at which they were originally sold. Since it involves more than buying and selling, implementing this concept can be complex.
Let’s consider an example.
Imagine you buy an apartment today at Rs Z and sell it two years later at Rs Z+X. The additional amount of Rs X represents the profit of this transaction. Many of these transactions first necessitate buying and then selling. However, revenue and loss are often erratic variables. A short-sell conducts the same transaction differently.
Why Sell Short?
Short-sell enables investors to profit from an overvalued stock. Investors can make money whenever a stock's price declines. Additionally, fund managers use short selling to protect against the downside risk of holding. For instance, you can sell short if you want to reduce losses without giving up a valued stock investment.
Example of short selling for profit
A trader predicts that the price of ABC stock currently trading at Rs 50 will drop over the next two months. To sell 50 shares to another investor, the trader will have to borrow 50 shares. Technically speaking, the trader is currently "short" 50 shares. The investor executes a short-sell considering the borrowed amount.
A few weeks later, the shorted company’s share had a poor quarter and experienced a financial decline, which caused the stock price to drop as well. Assume that the current stock rate of Rs 50 fell to Rs 35. The trader now decides to cover his short position by purchasing 50 shares for Rs 35. This will land the investor in a profitable position.
Example of short selling for a loss
Let's continue with the above example and assume that the trader has not closed the short position. However, the company is at a loss and has been taken over by a competitor. The takeover share price of the stock is now Rs 65. If the trader decides to close the position at the current price of Rs 65, which was initially Rs 50, the trader bears the loss of the difference amount. The trader will now have to sell the 50 shares at Rs 65. The trader had to purchase it back at a substantially higher price to cover the position.
An example of short selling as Hedge
Hedging is perceived as the lower-risk module of shorting. Here, protecting the shares is the primary objective, rather than making a profit. It moderates the losses in a portfolio. But the cost involved in hedging is significant and twofold. Certain expenses are associated with short-sell or premiums to be paid for proving protective contracts.
Let’s consider that an investor buys ten shares of Z Co. when the stock is at Rs 50. You will be at a loss if the stock price rises to Rs 60 or beyond. Therefore, you will buy one call option with a strike price of Rs 48, expiring a month from the current date. This call is trading at Rs 5, which will cost you Rs 50.
Pros and cons of Short Selling
This concept works well to ensure balance in portfolio management. However, short selling is akin to speculating which carries substantial risk.
1. Possibility of high profits
Short selling is commonly used by investors to make a profit. This can be achieved even when the market is falling and helps protect the portfolio.
2. Small initial capital required
The amount of money required to execute short selling need not be excessively high. it can be done with little money and may earn you profits.
3. Leveraged investments possible
If the seller predicts correctly and profits by short selling, they can make a return on their investment. This is possible if they have the margin to initiate the trade. Margin provides leverage, meaning the trader does not have to make the heavy initial investment.
4. Hedge against other holdings
Short selling is a low-priced method of protecting shares. This provides a counterbalance to other portfolio holdings.
1. Potentially unlimited losses
If the stock does not move as predicted, the trader can lose 100% of their outlay. The stock price can drop to infinity; there is no ceiling to the losses.
2. Margin interest incurred
Since short selling is about borrowing, it involves interest on the borrowings made and maintaining the margin. If the trader fails to maintain the margin due to market fluctuations, the trader might have to liquidate the position.
3. Short squeezes
This condition arises when the stock rises and all traders start to close the position. This leads to an increased share price.
Additional Considerations in Short Selling
The stock market is highly prone to fluctuations. Therefore, you must consider various other factors along with the risks involved.
1. Governing Risks
The stock market is quite broad. Governing risks may impose a ban on short sales in a specific sector. Short selling can create panic and selling pressure which leads to a sudden price hike. Traders may incur losses in the process of the closing position.
2. Wrong Timing
It takes considerable time for stocks to decline on an excellent-performing stock. However, stock prices do not decrease rapidly, and while a trader waits to book profit from the stock price, the investor is obligated to pay the interest and margin.
3. Shorting Uses Borrowed Money
To short-sell, the trader needs to open a margin account, which allows them to borrow money from the brokerage firm. However, losses can quickly mount when you go long on the margin because the trader must pay a minimum of 25% as maintenance. If the trader fails to meet this requirement, they will either have to liquidate the position or invest more.
4. The Short Squeeze
If the stock price falls, it will also experience a short squeeze. This phenomenon occurs when a stock begins to rise. The short-sellers cover their trades by repurchasing their short positions. This buying can lead to increased demand. Hence, it attracts more buyers, causing more short sellers to buy back.
5. Going Against the Trend
Historical data suggests that stocks have an upward drift. For instance, if a company has hardly performed well over the years, the price rate in the economy should drive its stock price.
Short Selling Metric
An investor must track short selling based on certain metrics. Traders consider two selling metrics, determining whether the stocks are under-valued or over-valued. Such metrics help understand the behaviour of the stock in the current market. It indicates whether the overall sentiment is bullish or bearish. Various stocks are measured in the volume of purchases and show the market trend. Therefore, a trader must also consider sentimental value.
● Short Interest Ratio
The ratio denotes the number of stocks shorted to the number currently afloat in the market. This helps determine the possibility of the stock price falling in the future. Conversely, a higher short-interest ratio denotes that falling stocks are over-valued.
● Day-to-cover ratio
The ratio represents the number of stocks shorted to the volume of stocks held in the market. Determining this ratio results in showcasing the standing of the stock in the market by demand. This is also called a short interest-to-volume ratio.
Ideal Conditions for Short Selling
1. During a Bear Market
With the volatility in the market, stock prices typically fluctuate. As a result, the decline rate is much faster, and the substantial gain might disappear in days or weeks. With this type of bearish development, short selling must be done precisely. It is also about grabbing the right opportunity. Since the stock's decline is erratic, the short seller must enter very slowly or not at all.
2. When Stock or Market Fundamentals are Deteriorating
The slowdown in revenue or profit growth challenges in business and rising input costs can be reasons for a deteriorating stock's fundamentals. It might include a string of more flawed data indicating a possible economic slowdown, adverse geopolitical developments, etc.
Experienced traders may wait before making short trades until the trend is confirmed because of the risk that a company or market may move higher despite worsening fundamentals, as it is during the final stages of the bull market.
3. Technical Indicators Confirm the Bearish Trend
There are multiple indicators of the bearish trend. It includes a breakdown below a key long-term support level or a bearing moving average crossover like the death cross. For example, a stock's 50-day moving average falls below its 200-day moving average. This occurrence is called the "bearish moving average." A moving average is the mere average calculated when a stock's price is over a period.
4. Short-selling Reputation
Short-sellers are viewed as ruthless operators of the market. It gets a bad name as it deflates the prices of vulnerable stocks.
Real-World Example of Short Selling
A short squeeze can be triggered by unexpected news events that may cause short sellers to buy at the existing market price to cover their position.
In 2008, it was stated that Porsche was bidding to gain majority control of Volkswagen. It was believed that once Porsche was in control, its stock market value would decline, resulting in short sellers heavily shorting the stock. Unexpectedly, Porsche announced that it had acquired over 70% of the company using derivatives. This resulted in a huge feedback loop of short sellers buying back their shares.
Alongside, the government possessed about 20% of the stock. This left short sellers at a disadvantage because the government entity was not interested in selling stock. Porsche controlled 70%, leaving only a small number of shares floating on the market.
The interest on the short and the days-to-cover ratio hit the roof in one night, causing the stock to blow up from just €200 to more than €1,000.
This trend faded quickly. After a few months, Volkswagen stock had recuperated its usual market spot.
The Risk of Short-Selling
The primary risk in the world of stocks is the possibility of losing money. Traders hop on the techniques and tactics to avoid losses, which also come with a disclaimer. Here is a breakdown of the risks associated with a short-selling strategy.
1. Short Selling Uses Borrowed Money
Short sellers use borrowed money, so a margin account is a mandate. This allows them to borrow a percentage of the trade from the broker. In the margin account, traders must always have a minimum balance of 25% of the trade. If you fail to meet the minimum balance, the broker will send a margin call, which demands liquidation.
2. Bad Timing
Another risk is the company's valuation. Even when the company might be overvalued, it could be a while before the price decreases. This will make the trader pay the interest, and it might fall below the maintenance balance.
3. Shaky Regulatory Sector
With the fluctuating behaviour, authorities might ban short selling from some specific sectors. This may lead to spiked stock market prices, forcing the short seller to account for huge losses.