Bear markets are often characterized by losses in the market, but it is not the case. There are various strategies and techniques which can prove out to be beneficial in a bear market. One such technique is short selling or shorting.
Short selling is the technique, which helps investor in extracting profits out of falling prices of stocks. It is a very simple concept, where an investor sells the stock first by lending it and buys it later to return the same to the lender.
This process helps the investor in selling the stock at a higher price and buying it later in a bearish market at lower price, thus generating profit. However, if the market bounces back, the investor will have to buy the stock at a premium and face loss.
Therefore, short selling in other words is simply betting that the stock prices will fall. It is a risky technique because there is no limit to the amount which you could lose in the market. Short selling is also used as a speculation and hedging technique.
Let us now understand, why investors go for short selling and how do they earn profits by shorting the stocks.
Table of Content
Steps Follow for Short Selling Stocks by Investors
Understanding Short Selling
Let us now understand short selling with a very simple example. An investor, Mr. A think that the stocks of XYZ company are overvalued at 100 Rs per share and can soon drop in price. In such a scenario, Mr. A will borrow few shares of XYZ from his broker, and then sell them at the current market valuation of 100 Rs. per share.
After some time, suppose the stock falls to level of 80 Rs. per share. Now here, Mr. A can buy the stock back and return the same to his broker. In the above scenario, even though the stock had a bearish movement, Mr. A earned a profit of 10 Rs. per share. However, if the stock prices have bounced back to level of 150 Rs per share, Mr. A would have booked substantial loss.
Risks of Short Selling
Short selling is considered as a risky affair because the risks incurred are amplified risks. The loss in case of short selling has no limit. In case of normal investing, the maximum amount of risk that an investor is exposed to at any given point of time, is the amount which he has invested. For example, if we buy 10 shares of a company at Rs. 10 each, the maximum risk which we will face will be 10 Rs per share, because the stock prices can never fall below zero.
However, in case of short selling, the investors can theoretically lose infinite amount of money because the price of the given stock can rise forever.
Why is Short Selling Used by Investors?
Short selling is usually used by the investors for hedging and speculation. Short selling is used by speculators to capitalize the declining levels across a particular security or the whole market, whereas hedgers short sell for mitigation of losses in the given asset.
Institutional investors engage simultaneously in both hedging and speculation. Short selling can prove out to be very beneficial in a declining market but carries high risks. Therefore, it is recommended to have a sound knowledge and experience about the market. Thorough research into the fundamentals of a company can help you speculate the opportunities for short selling.
When Should You Short Selling?
Short selling is not recommended and neither used by majority of the investors. Investors prefer to invest in rising stocks because the risk in that case is limited. Moreover, the markets in the long run have a tendency to rise. There may be phases in between where the market may fall but at the end, it tends to go up.
Conclusion
For investors who enter the market with a long-term horizon, it is always recommended to buy stocks rather than short selling them, because buying stocks is any day less risky. Short selling makes sense when you are confident that a company or stock will surely drop in value in the short-term. Such speculations can be made by researching the fundamentals of a company. For example, if the operations of the company are experiencing difficulties or there are huge debts, there may be a decline in the prices of its stocks. A certified investment advisor can help you in carrying our extensive fundamental research about the companies and provide you recommendations based on the same.
