Elon Musk, CEO of Tesla Motors, has become infamous for his controversial tweets.
His most recent target was short sellers. Musk tweeted that short selling should be made illegal because it causes negative pressure on GDP and can incentivize fraudulent behavior by investors and regulators.
While most long-term investors attempt to make money in the stock market by identifying individual stocks or exchange-traded funds that they believe will rise in value over time.
However, certain investors actually profit off bets whose share prices go down, not up.
In this article
What is Short Selling of Stocks?
Short selling is a strategy involving the sale of a stock that the investor/seller does not own or has borrowed.
Gains from short selling are realized when the price of the stock declines and the seller buys back the stock at a lower price.
Let’s use an example to demonstrate it. Say you’ve been reading up on Company ABC, and you are certain the value is going to go down, and soon.
A lot of investors who believe that simply won’t touch the stock. A short-seller, though, will act.
For Example: Company ABC shares are currently worth ₹100 each. The short-seller may borrow 20 shares from their lender or broker, and then sell them. 100 x 20 = ₹2,000.
Perhaps ABC’s shares fall down to ₹80. The short-seller buys back the shares and has made a profit.
Well, there were 20 shares, and each share declined ₹20. ₹20 x 20 shares = a net profit of ₹400.
In India, short selling in the cash market can only be held on an intra-day basis. In the futures and options market, it can be held for longer.
Short sellers tend to be risk-seeking speculators or investors seeking to hedge losses from long positions in their portfolio.
If the stock price increases against the expectation of the seller, then this strategy will result in unlimited losses, being that there is no defined absolute limit on the level of losses that can be incurred.
Short selling is therefore a very risky strategy.
8 Reasons long-term investors avoid Short Selling
Short selling is challenging and risky and is typically avoided by long-term investors because of the following reasons:
1. High Level of Risk
While there is a promise of high returns in short selling, the degree of risk is also high. If you trade in shares, you can only lose the amount you have invested.
So, if you buy 1000 shares of a certain company at ₹20 each, you stand to lose a maximum of ₹20,000, if the share price falls to nil.
However, in case of short selling, the amount of losses you can make is technically infinite since the share price of the given company can rise to any amount and you have borrowed the shares rather than owning them.
So, your upside is capped and your downside is unlimited – precisely the opposite of long investing.
2. Short-term Investment Horizon
Short selling is typically a short-term strategy but some sellers perceive it to be a sell-and-hold strategy to be executed with a long-term investment horizon.
With this perception, the long-term upward trend of the market works against the seller who is left to fill lofty levels of margin calls as stock prices usually exhibit an upward tendency over the long-term.
3. Borrowing Fee
Like many things in the stock market, borrowing shares of stock isn’t free.
Short sellers must pay brokers a borrowing fee.
Unfortunately, some of the most popular stocks among short sellers have some of the highest borrowing fee.
Like rest of the market, borrowing fee fluctuates based on supply and demand, and the fees associated with some of the most heavily shorted stock can approach 100% of the value of trade on an annualized basis.
These borrowing fees mean short sellers are already starting out in the hole as soon as they take a position.
4. Paying Interest
There are also costs that aren’t there for stock buyers. An investor shorting stocks will have to pay interest on his/her borrowed shares.
While it can start out in single-digit percentages of the money placed on the short position, that rate can increase over time if the stock becomes a popular name to short and demand for borrowed share increases.
5. Not Earn a Dividend
Dividends are one of the major perks of owning high-quality stocks in the long-term.
Since the shares sold short are only borrowed, the original owner is still entitled to the dividend payments.
The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed.
Paying that dividend is an obligation that falls on the short seller. The higher the dividend a stock pays, the more expensive it can become to sell it short.
6. Risk of Short Squeezed.
A short seller’s worst nightmare is a market phenomenon known as a short squeeze.
When a stock has a high short interest, any significant move higher in share price can trigger panic among short sellers.
In order for short sellers to close out their positions, they must first buy back the shares they owe. That buying can drive a stock’s share price even higher, enticing even more buying in the market.
As the effects of the squeeze compound, share prices can skyrocket in a matter of days or even hours, inflicting huge losses on short sellers.
7. A Decision Against the MarketTrend
From a practical standpoint, perhaps the best argument against short selling has nothing to do with fees, risks, short squeezes or interest.
History has shown that, in general, stocks have an upward drift.
Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.
While stock buyers are simply along for the ride, short sellers are swimming against the current by betting on lower prices.
8. Regulatory Risk
Regulators may sometimes impose bans on short sales in a specific sector or even in the broad market to avoid panic and unwarranted selling pressure.
Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.
Short selling should not be seen as a sell-and-hold strategy.
Short selling has a short-term horizon and needs active management in case the trade goes south, leaving the seller ready to exit the trade.
One of the biggest advantages long-term investors have enjoyed throughout the decades is the remarkably consistent returns the stock market has generated over time.
Therefore, short selling should be left to very experienced investors, with large portfolios that can easily absorb sudden and unexpected losses.
Disclaimer: The views expressed in this post are that of the author and not those of Groww