28th January, 2023 Economy
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- Short seller Hindenburg Research has disclosed short positions in Adani Group, alleging stock manipulation and accounting fraud in its latest investigative report.
Buy Low Sell High:
- “Buy low, sell high” is the traditional investment strategy in which one buys a stock or security at a particular price and then sells it when the price is higher, thereby booking a profit. This is referred to as a “long position”, and is based on the view that the price of the stock or security will appreciate with time.
- Short selling, or shorting, on the other hand, is a trading strategy based on the expectation that the price of the security will fall. While fundamentally it is based on the “buy low, sell high” approach, the sequence of transactions is reversed in short selling — to sell high first and buy low later.
- Investors, who short sell stocks, expect share prices to drop on a future date and aim to capitalize on this prediction.
- Since it depends on speculation and entails infinite risk theoretically, only seasoned investors partake in short selling.
- When prices drop, traders make a profit from the difference between the selling price and the purchasing price.
- Also, in short selling, the trader usually does not own the securities he sells, but merely borrows them.
- In the stock market, traders usually short stocks by selling shares they have borrowed from others through brokerages. When the price of the shares falls to the expected levels, the trader would purchase the shares at the lower price and return them to the owner, booking a profit in the process. If, however, the price of the shares appreciates instead of falling, the trader will be forced to buy shares at a higher price to return to the owner, thereby booking a loss.
Watch these Videos for Conceptual Clarity:
When is Short Selling Profitable?
- Short selling is profitable when a trader speculates correctly, and share prices do fall below the market price at which a trader sold short. In that case, a trader gets to keep the difference between the selling price and purchasing price as profit.
Short selling example –
- Rahul speculates that the current market price of stock ABC at Rs.200 is way overvalued and expects that once its quarterly financial reports are out in a week, its share price will drop. He borrows 20 ABC stocks and sells them in the market at Rs. 200, thus getting "short" by 20 stocks. In a week, as predicted, the price of ABC stocks starts to fall and reaches Rs. 175. He then repurchases those 20 stocks at the lower rate of Rs. 175, thus pocketing Rs. 25 per share as profit and earning an overall profit of Rs. 5000 (Rs. 25 x 20). He then gives back those stocks to the original broker.
- Even though, theoretically, Rahul profits Rs. 5000, in reality, there is interest on the borrowed stocks and commissions that an investor needs to pay. And depending on the timing of selling short, a trader might also need to pay a dividend to its buyer.
- Additionally, a stock might be overtly shorted by other traders that might cause a paucity of the stocks available with a broker. In that case, the borrowing costs might be steeper. Also, even after borrowing, there is no certainty that a trader will find buyers and sellers in the subsequent stages.
When Does Short Selling Result in Loss?
- When a trader predicts wrongly about the declination of share prices, they stand to lose infinitely. The term "infinite risk" particularly applies to short selling where the modus operandi is "sell high and buy low".
- In the conventional trading approach, a trader purchases shares at a specific price and expects it to rise in the future when she can sell it to earn profits. In that case, even if the share prices fall a trader only stands to lose to the extent of her investment, thus limited risk.
- In case of short selling stocks, if contrary to prediction share prices surge, it can skyrocket infinitely, thus exposing a trader to unlimited risk.
Short selling example –
- Ruth speculates that PNM stocks will fall in value from its current market price of Rs. 100 when the company announces its dismal annual reports in the next week. Relying on this speculation, she borrows 15 PNM stocks and concludes short selling in the stock market at Rs. 100/share.
- However, just after the annual report's announcement, the company was overtaken by a reputed conglomerate, thus driving its share prices upwards to Rs. 110. Ruth then decides to close the position and buy back the shares at the increased market rate. She, therefore, realizes a loss of Rs. 10/share, and Rs. 1500 (15 x 10) overall in addition to the interest and commission.