What is Short Selling? Is It Good or Bad?

Should Retail Investors Do Short Selling?

Introduction

What is Short Selling? Is it good or bad? Should Retail Investors Do Short Selling? Is Short Selling Suitable for Long-term Investors? In this article, we will discuss the concept of short selling and its repercussions on investor’s portfolio.

Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money. Short sellers bet on, and profit from, a drop in a security’s price. Basically, the Short selling has a high risk/reward ratio : It can offer big profits, but losses can mount quickly and infinitely.

What is Short Selling? Is It Good or Bad?

• Selling the shares (which you do not have in demat account) by borrowing from the broker on margin is called short selling. Short selling happens when there is a bearish trend in the market and investors expect the prices of shares to fall.
• These shares are lent to the seller by the broker with a promise that they will be delivered back to the broker at the time of settlement.
• If the price of a stock that the seller has shorted falls, he can buy back the stock at the lower price and make a profit. However, If the price of the stock rises, he has to buy it back at the higher price, and will incur a loss.

What is Short Selling – Explained with Example

• Let us take an example of Mr. Gaurav, who wants to short sell 1000 shares of Reliance Industries trading at INR 1800. So he puts an order in his trading account to short sell shares of Reliance Industries.  So here the total trade value will be 1000 * 1800, which equals INR 18 lakh.
• For short selling, one needs to have a margin account and Mr Gaurav will have to deposit some margin with his broker. The amount of margin required varies with the trade value and from broker to broker.
• Now lets say the stock price comes down to INR 1750 per share, Mr Gaurav decides to square off the trade by buying the shares. His net profit comes to 1000 * (1800-1750), which is INR 50,000.

• Depending upon the type of segment the trade is placed in (cash or futures), if an investor fails to cover the trade, broker will automatically square off the trade by purchasing the shares at the market price on the end of trading session.
• This looks much simpler to execute and earn profits, but in reality short sell is not that straight forward.

Let us further discuss the nitty – gritty of short sell.

Actual Beneficiary of Short Selling?

• Short sell is mainly based on speculation and irrespective of the market movement, broker will earn profit. Let us see how
• Since in short sell , an investor will sell the shares and is obliged to buy them later, he will have to pay brokerage on both the transactions (buy and sell). This will result in broker earning profit in this trade even if the investor does not.

Should Retail Investors Do Short Selling?

• The retail investors trading volume reached 70,000 Crore in June’20. This is indicative of the presence of robinhood traders in the market, which is giving a speculative nature to the market.
• In such a trading environment, let us see the impact of short selling on a retail investor’s portfolio.

• If an investor decides to indulge in such short-term gimmicks to earn some extra returns, it will definitely hamper his long-term trading thought process.
• Stock’s rally/bull runs occur for a very short period and they offer a good opportunity for earning stupendous returns on your investment. If an investor misses these rallies as a result of indulging in short-term trades, it results in change of thought process from participating in long-term disciplined investing to short-term speculation.
• This might become an addiction and there is high risk involved in such trades. This can eat up his portfolio returns as well as capital, in extreme cases.
• We feel it is better for long term investors to stay away from such speculative trades in market.

Conclusion

• Trading strategies like short sell are suitable for traders and not for long term investors.
• Once an investor gets addicted to earning short term gains, it becomes difficult for them to get back the discipline and patience of long-term investing.
• Portfolio’s long-term returns should not be disturbed for short term gains.
• We feel long-term investors should invest after thoroughly researching about the company. They can take help of technical analysis only to figure out the entry and exit points. But it should not be used to enter into speculative trades.

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