Shorting of stocks or short selling is a trading strategy where you first sell a stock you don’t own and then buy it later. In brief, you would borrow the stock and sell it at a higher price while later buying it at a lower price and returning it to the lender. The difference between the two becomes the profit you pocket. This is in contrast to regular trading, where you buy low and sell high.
SEBI allows short selling on an intra-day basis. This means that you cannot push buying the stock you sold off to another day; you will have to buy it before the market closes on the very same day, or the broker will buy it for you at any rate when the market is about to close.
Let’s suppose the stock of Reliance Industries is trading at Rs 2,400 per share, but you have a solid belief that the stock price will go down to about Rs 2,200 per share due to some regulatory announcement that impacts the company. So, you decide to short the stock. When the market opens, you sell 10 shares of Reliance Industries at Rs 2,400 per share. Thus, you get Rs 24,000 in your Demat Account.
As anticipated by you, the stock starts falling and tumbles down to Rs 2,200 per share. You immediately place a buy order for 10 Reliance Industries shares at Rs 2,200 apiece. As a result, your Demat Account will be debited by Rs 22,000. Thus, you make a profit of Rs 2,000.
Taking a short position is a highly risky trading strategy. Since the stock market is highly volatile, there are no guarantees that your anticipation will hold. For instance, if one of your stocks to short, like Reliance Industries in the above example, did not react to market news and went on an uphill ride, you would end up booking a loss. Since the intra-day trade has to be executed before the market closes, there may not even be a limit to the losses you may have to bear if you hold on to the hope of the stock price coming down.
Short selling stocks may be a worse idea for long term investors. Here’s why.
The ‘buy and hold’ strategy best suits those looking to fulfil long-term goals and save for landmark events in life like children’s education, retirement, children’s marriages, and even having a considerable corpus for rainy days. Timing the market and shorting stocks may lead to losses in the short term.
The temptation to sell a stock and wait for it to fall just a little more can be more detrimental than rewarding. If the stock does not fall or faces a minor dip and rises sharply, it may lead to losses. Waiting and hoping the stock comes down may prove even more dangerous since there would be no limit to the losses since there is no upper limit to how much the stock price can rise. For long-term investors, this may go against the principles of value investing which defies the fundamental analysis of stocks.
Do you recall the extravagant spike in the share prices of AMC Entertainment and GameStop early this year in the U.S?
Well then, you must know how the wealth of multi-million dollar hedge funds were wiped out in a matter of days due to the negative repercussions of shorting. This happened due to a trend known as ‘short squeeze’.
When a stock is being heavily shorted in the market, the demand for the stock rises, which pushes the price of the stock up. In a vicious cycle, short-sellers rush to buy the stocks as the price continues to rise and breaches a point where it is artificially inflated. As a result, there remains no scope for the investor to profit but only cut their losses and exit the trade.
While you may not make many gains via shorting, shorting stocks in India can also burn a hole in your pocket. Since you are borrowing the stocks from your broker, who borrows it from someone else, you will have to pay a borrowing fee to the broker to facilitate the transaction.
In addition to this, you will have to pay additional interest on these borrowed shares while also paying the dividend to the shareholder for borrowing the stock.
Short selling of stocks requires a strong knowledge of the stock market and an understanding of inherent risk and price movements to ensure a cap on losses. Despite this, even seasoned investors have been known to book losses of scale due to the market’s high risk and unpredictable nature. The chances of colossal losses run extremely high with shorting of stocks while it may simply be a wrong idea for long-term investors.