Investing in stocks, when done well, is among the most effective means of long-term wealth creation. Savvy investors educate themselves on the risks of various attractive and effective wealth creation strategies that are out there.
What is short selling?
It is a trading strategy that speculates on the decline in the price of a stock or any other security. Here, the investor aims to make money when the value of the stock falls. This is contrary to the usual strategy of buying a stock in the belief that its price will rise and profits could be made by selling at the increased price.
How does short selling work?
Imagine a trader who believes that the value of company X’s stock, currently trading at Rs 100, will fall in the next 3 months. This trader then borrows 100 shares of company X and sells them to another investor. The trader is now 100 shares short. Suppose, a little later, company X reports poor performance, causing its stock to fall to Rs. 90. The trader could decide to close the short position and buy 100 shares of company X at Rs. 90 to replace the borrowed shares.
The trader would earn a profit of Rs. 1,000 on the short sale (Rs. 100 – Rs. 90 = Rs. 10 x 100 shares = Rs. 1,000) excluding commissions and interest on the margin account.
However, it is also possible that company X’s stock price rises. In that case, the trader could either hold his short position (and hope that the price will fall) or close out the position at a loss.
Short selling is an advanced strategy, and financial experts strongly recommend that it be undertaken only by experienced investors with a good understanding of the process as well as of the associated risks of short selling stocks.
Here are 10 reasons why we think that shorting stocks is a bad idea, especially for newbie investors:
- The potential for losses is unlimited because there is no ceiling for a stock’s price.
- Regulatory risk of a possible sector-specific or market-wide ban on short sales to avoid panic and to defuse selling pressure. This would cause a spike in the stock prices, forcing the short seller to cover short positions at a potentially huge loss.
- Historically, the value of stock prices has shown an increase over time. Short selling is, therefore, a bet against the general overall direction of the market.
- The possibility of a short squeeze – when a stock begins to rise, short-sellers start buying their short positions back. Demand for the stock rises further, causing a feedback loop that rapidly pushes the prices up in a very short time inflicting heavy losses on short-sellers.
- As opposed to buying and owning stocks, short selling entails substantial costs in addition to the usual broker commissions, including having to pay brokers a borrowing fee.
- A short seller is required to pay interest on the borrowed shares. The cost of interest can increase if the demand for the stock increases.
- The short seller needs to make dividend payments on the shorted stock. Higher the dividend that the stock pays, the higher the cost of selling it short.
- Short-sellers need to bear the administrative overhead of operating a margin account.
- It could take a long time for the stock price of an overvalued firm to fall. In the interim, the short-seller is liable to bear expenses like interest or dividends.
- Suited only for investors with a short-term investment horizon since the stock market generally exhibits a rising trend in the long term.
It is crucial that you understand the market dynamics very well before undertaking any form of speculative investments. The best way to handle stock market investments, especially for retail investors is to let professional financial advisors guide them on an effective financial plan to reach their financial goals comfortably.