What is Short Selling of Stocks

Short-Selling, or Shorting is often in the news for all the wrong reasons. In contrast, short sellers make the market more efficient, balanced and matured.
Let us understand what short selling is, and how does it help the markets.

Before we understand short-selling, we must also understand what long-selling is.

Long-Selling (Selling Long / Taking a long position / Going long)

Selling long (or going long) on a security or an investment means that an investor buys that security or investment with the prospect of keeping it for some time because he or she believes that its price (or value) is going to increase in the long run. This investment action is called a long position in that particular security or investment.

This is what most of you are usually aware of. This is why you analyze a stock for long term. You try to get good companies at undervalued prices, and then keep them for long term until the prices of such companies recover to the expected value. You make money by buying low and selling high. Remember - you buy first (at a lower price) and you sell later (at a higher price). 
[Recommended Book - The Autobiography of a Stock]

Simple, right? But humans are not a breed which would like to keep things simple. They love to complicate stuff, and that is precisely where comes Short Selling

Short-Selling (Selling Short / Taking a short position / Going short / Shorting)

The opposite practice to long selling is known as selling short or short selling a security or an investment. An investor who gets involved in short selling believes that the price of the underlying security is going to decrease in the near future. 

Hence, that investor borrows shares of the security he or she anticipates will have a price decrease (remember that he does not own the shares - he or she has just borrowed), and then sells those borrowed shares at the current market price. The investor is now expecting to pay back the borrowed stocks when the price of the security drops. And when the price does drop, the investor buys those stocks to repay the borrowed stocks. 

This way the investor makes a profit by (first) selling high and (later) buying low. Remember that the investor sells first and buys later. 

Thus, because the investor does not own the underlying security but only borrows and sells it first, it is considered that that investor is in a short position regarding that particular security.

In reality, because of technology, when you short a stock, you will not need to borrow these shares. All you need to do is to select the number of shares you want to short and implement the transaction right away.

Risks in Long Selling Vs Short Selling

When you long a stock, the maximum loss that you can make is your invested amount. For example, if you bought shares worth Rs. 10,000, the worst thing that can happen is for the stock to drop to Rs. 0. So, the maximum loss is Rs. 10,000.

In longing, while the loss is capped, the gains can be theoretically infinite depending on how high the stock prices can go.

Short selling, on the other hand, is riskier because it just works the opposite way. Since there is no limit on how high a stock can go, as such, it is often said that the maximum loss that you can make when short selling is infinite. When a stock you are short makes a parabolic rally, the situation is known as a short squeeze. 

For example, if you borrow and sell 10 shares of a company currently worth Rs. 10,000 (Rs. 1,000 per share), and expect its price to drop (since you are shorting) - the reverse may actually happen i.e. the stock may rise to Rs. 2,000 or 3,000 or, for that matter, anything. So, the maximum loss can be Rs. 10,000 or Rs. 20,000 or for that matter, infinite.

In shorting, while the gains are capped (because the stock cannot dip below 0), the losses can be infinite.

This makes short selling much riskier than long selling.

Short squeeze example

Historically, there have been many short squeezes. For example, for years, many value investors talked about how overvalued Tesla was because of its massive losses. As such, many of the short sellers went on and shorted the stock. During the pandemic, the stock soared so high, pushing the company to become the most valuable automaker in the world. This price action led to losses worth billions of dollars to short sellers.

Legality of Short Selling

Short selling fell under heavy scrutiny during the global financial crisis of 2007 and 2008 when Australia, Canada and several European nations placed bans on short selling of financial stocks. Since that time, regulations have been lifted or amended in some countries.

For decades, certain politicians and prognosticators have alleged that short selling can actually help cause market declines and recessions. There are several reasons why a country might ban short selling. Some believe short selling en masse triggers a sale spiral, hurting stock prices and damaging the economy. Others use a ban on short sales as a pseudo-floor on stock prices.

Short Selling is legally allowed in a lot of countries today, including USA and India.

Benefits of Short Selling

According to Jones and Lamont (2001), short selling makes an important contribution to the efficiency of the stock market. There are limits to arbitrage. Specifically, some stocks can become overpriced. A group of investors may realize this and adopt a short position in those overpriced stocks. When the stocks are sold in the market, their prices are driven downward (high supply, low prices), and eventually they reach an equilibrium price level.

Most economists and investors believe short selling is an important part of the price discovery process and helps highlight flaws in company fundamentals, which sends important signals into the market. For example, short selling can assist with more efficient price discovery, hedging other investments, increasing market liquidity and lessening the impact of bubbles. Nevertheless, short selling is often misunderstood and therefore considered a risk.

One of the major recent examples of short selling was that of Adani Stocks by the short seller - Hindenburg Research. Adani stocks were indeed overpriced and there was no way to bring the sentiments down to a reasonable level. That is when Hindenburg Research - one of the famous short sellers - showed the overvaluation of Adani stocks and must have made a humungous money by short selling - since some of the Adani stocks crashed by as much as 90%. Yes, they made money, but they did bring sanity to the stock prices which were just leading to a massive bubble that would have hurt the market worse in the times to come.

We covered a big article on Hindenburg Research on Adani stocks on the March edition of our ELEVATE newsletter. You might have read the details on the same.

Conclusion:

Short selling is not for inexperienced traders and speculators who are not aware of the inherent risks in the activity. It is far riskier than long selling - in fact infinitely riskier (theoretically) than long selling. Though it brings equilibrium and sanity to the market, it should be a pass for a common retail investor looking to build long term wealth. It is an essential strategy for the market, but best dealt by seasoned market speculators.

Regards

Manoj Arora
Official Website