In this blog, we will understand the concept of shorting a stock and will try to understand its merits and demerits vis-a-vis other strategies.
The stock market has always been an enigma to the uninitiated. Legends of traders striking rich in one single day have always done the rounds and will continue to do so for some time. The fact that someone can earn a large sum, enough to live comfortably in the future, makes the stock market alluring to the layperson. Millions have set out to invest in the stock market trying to catch that one big break. But it is only when you sit down and try to understand the inner workings of the market, that it is rather the exception than the norm.
At the basic level, a stock market is simply a place where buyers and sellers meet to trade various products, in this case, stocks, bonds, options etc. Now, we know about the buyers of the stock, who buy an asset hoping it will appreciate in the future and thus, which can be sold for profit. We also know that there are sellers who feel that a stock’s price has reached its peak and will not increase further, and thus sell it. But what if there is a third kind of trader, who sells stocks before buying them.
Today, we will cover the following points:
- What is Short selling
- An example to understand short selling
- Difference between Short and put
- Risk of shorting a stock
- Reward of shorting a stock
- How to tell if a stock will go down
If an individual looks at a company’s stock price and thinks that it is overvalued, they can do the following things:
- Borrow the stock - Usually, a trader can borrow stock from the broker while guaranteeing that he will deliver the said stocks in the future.
- Sell the borrowed stock - The trader would sell the borrowed stock to a buyer at the current market price.
- Buy the stock at a lower price - Depending on the agreement, the trader will then wait till the price of the stock goes down so he can buy the borrowed stock and pocket the difference.
On 22nd January, Tesla closed at $304 on the NYSE. Now, if we had researched the company and come to a conclusion that the stock was overvalued and would be on the downward trend soon, we could borrow 10 stocks from the broker by paying a fee promising that we would deliver the said stocks tomorrow end of the day.
At the same time, since Tesla’s stock is in demand, we find a buyer in the morning of 23rd who is willing to buy 10 stocks at the market price i.e. $304. Thus the buyer agrees to pay $3040 for 10 stocks.
Due to certain market conditions, the stock decreases in value to $292 at the end of the day.
Since we had agreed to buy the borrowed stock from the broker, we pay $2920 for 10 stocks of Tesla. As the buyer had agreed to pay $3040, we receive the said amount and in this way, we profit by $3040 - $2920 = $120.
We should understand that there are brokerage and certain costs associated with shorting a stock which has not been mentioned to maintain the simplicity of the concept.
Compared to “going long”, there is a perception that short sellers are pessimistic individuals who are betting against the company’s growth. At first glance, short sellers want the price of a stock to go down so that they can profit.
“But why do they hate us?” - Anonymous short seller
Over the years, though, investors have understood that for a market to function efficiently, there should be a healthy mix of both, buyers and sellers. It has been observed that short sellers are needed to maintain liquidity in the market.
A short seller is also a counter to any company which might be overvalued or inflating their balance sheet to attract more capital. Usually, people spend more time researching for a stock to short and thus, a company’s shortcoming can come to light.On the surface, it might look the same, but as you dig deeper, you will find that there is one fundamental difference. A put option is not obligatory but a choice to the buyer ie an option to exercise the “put” or not.
In brief, you can buy an option to sell a stock or security at a fixed price (strike price) on or before the predetermined time.
Thus, if the price of the stock stays below the strike price, you can exercise the put and post a profit. If the market price of the stock goes above the strike price, then you let the put expire and the only loss you incur is the premium you paid the broker for the put.
In the case of Short selling though, you have to cover the trade irrespective of the fact that you post a profit or not.There is a general consensus that short selling is for sophisticated investors or major hedge funds. This is somewhat true because in comparison to going long, short selling can put a major dent in your account.
Taking the same example as before, in the case of Tesla, let us suppose a short seller had shorted the stock by buying 10 stocks at $304 per stock on 22 January for a total of $3040. Now, due to certain favourable market conditions, the stock rallied upwards to close at $320 the next day, this means that if the short seller closed the trade at the end of the day, they would have posted a loss of $160. Usually, short sellers have to be vigilant with the stocks they have shorted, in case the trade goes against their favour.
Thus, a short seller is usually a seasoned veteran who knows the ins and outs of the company he is going to short and is willing to take the risks.Over the years, there have been individuals who have struck jackpot by short selling. Some have achieved cult status due to one short sell in the past. Soren Aandahl is one of them. In his time at Glaucus Research Group as director of research and CIO, he has reported 28 cases of opinion reports stating his reasons to short the selected companies. The market always reacted to the reports and some companies were charged for misrepresentation too. Not only was the market made aware of the true nature of the companies, but it was also reported that his investments returned 51% compared to a negative 4% of the short community.
It is worth noting, however, that if you have done the required homework, the potential profit could be significant.While trend indicators are not exactly the first thing to come to mind when it comes to short selling stocks, it is a good starting point when you want to test the waters before you plunge in. A simple trend indicator like Moving averages, MACD, Bollinger bands could help you identify the downward trend for a stock. You can try out the starter pack on algorithmic trading to further your knowledge in the stock market. Suggested reads:
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.