When it comes to investing you can divide the whole pie into two pieces: Long and Short. Long investing means you’re expecting the price of the security (usually a stock) to go up hence you buy the stock and hold it until it rises enough to make sizeable profits. But if you anticipate a fall you can still make a profit from the deal by doing something unconventional that is short selling.
What is Short Selling?
If you sell a stock you don’t own, you are selling short. (Yes, it’s legal.) A short seller sells a stock that he believes will fall in value, he does not own the stock before he sells it. Instead, he borrows it from someone who already owns it. Later, the short seller buys back the stock he shorted and returns the stock to close out the loan. If the stock has fallen in price since he sold short, he can buy the stock back for less than he received for selling it. The difference is his profit.
For example, in September 2016, Chandrika thinks HLL is overvalued. She sells short 100 shares of HLL at Rs 250 per share. The stock market crashes in November and HLL’s share price falls to Rs 210 per share. Chandrika buys back 100 shares of HLL and closes out the short sale. She gains the difference between the sales proceeds and the purchase costs and pockets Rs 4,000 from the short sale, excluding transaction costs.
Why Sell Short?
There are two primary reasons for selling short ie opportunism and portfolio protection. Occasionally investors see a stock that they believe has been hyped to a ridiculously high level. They believe that the stock price will fall when reality replaces the hype. A short sale provides the opportunity to profit from the overpriced stock. Short sales are also used to protect an investor’s portfolio against a market downturn. By shorting stocks that the investor believes will fall sharply when the market as a whole falls, investors can help insulate the value of their portfolios against sudden market drops.
Short selling is also used to protect portfolios against erosion due to a broad market decline. Short sellers make money when stock prices fall. An investor can diversify a long portfolio by adding some short positions. The portfolio will then have positions that make money both when prices rise and when they fall. This reduces the volatility in the portfolio’s returns and helps protect the value of the portfolio when prices are falling.
By shorting carefully selected stocks that are priced near their peak but that will fall sharply if the market falls, an investor can use the profits from the short sales to help offset losses in his long position to protect the value of his/her portfolio.
Risks of Short Selling!!
There are risks to short selling. The most obvious risk is that the stock price can rise and continue to rise. The price of a stock can rise much higher than it can fall, and therefore there is equally a potential for loss even greater than the potential profit.
Conclusion
Investing is all about learning to make money out of one’s accumulated savings. It needs a sharp mind and an ability to think out of the box. There are substantial risks and pitfalls that you need to watch out for. The mechanics of a short sale are somewhat complicated and the investor’s risks are high so it is important that you understand the transaction before getting into it.
