What is Short Selling
Traditionally the premise of investing is that you
buy an asset and hold it until it rises enough to make a
sizable profit, it doesn't get much easier than that.
What about the times you come across a stock that you
wouldn't invest a penny in, you know that stock is
doomed, a sure loser. If you knew that the stock was
going to decline wouldn't be nice to be able to profit
from its decline.
Well you can profit from the decline of a stock and
although it sounds easy, there are substantial risks and
pitfalls that you need to watch out for. The mechanics
of a short sale are somewhat complicated and the
investor's risks are high so it is important that you
understand the transaction before getting into it.
What does it mean to sell short?
If you sell a stock you don't own, you are selling
short. (Yes, it's legal.) You are now short the stock.
A short seller sells a stock that he believes will fall
in value. A short seller does not own the stock before
he sells it. Instead, he borrows it from someone who
already owns it. Later, the short seller buys back the
stock he shorted and returns the stock to close out the
loan. If the stock has fallen in price since he sold
short, he can buy the stock back for less than he
received for selling it. The difference is his profit.
Short selling allows investors to profit from falling
stock prices. "Buy low, sell high" is the goal of both
short selling and purchasing shares ("going long"). A
short sale reverses the order of a typical stock
purchase: the stock is sold first and bought later.
For example, in March 2002, Andy thinks HLL is
overvalued. He sells short 100 shares of HLL at Rs. 250
per share. The stock market crashes in April and HLL's
share price falls to Rs. 210 per share. Andy buys back
100 shares of HLL and closes out the short sale. Andy
gains the difference between the sales proceeds and the
purchase costs and pockets Rs. 4,000 from the short
sale, excluding transaction costs.
Where Does The Broker Get The Stock?
The short answer is from other customers or the Stock
Holding Corp. of India.
Short selling is a marginable transaction. In plain
English, that means you must open a margin account to
sell short. This is the same account you would use if
you want to use your stocks as collateral margin to
trade in the markets.
When you open a margin account, you must sign an
agreement with your broker. This agreement says you will
maintain a cash margin or pledge your stocks as margin.
How Do I Sell Short?
Unlike a stock purchase transaction, which involves two
parties (the buyer and the seller), short selling
involves three parties: the original owner, the short
seller, and the new buyer. The short seller borrows
shares from the original owner, and immediately sells
them on the open market to any willing buyer. To
finalize ("close out") the short sale transaction, the
short seller must then go out into the stock market and
buy the same amount of shares as he sold so that the
broker can return them to the original owner.
To sell short you first must set up a margin account
with your broker. A margin account allows you borrow
from your brokerage company using the value of your
portfolio as collateral. The general rule is that the
value of your portfolio must equal at least 50% of the
size of the short sale transaction. In other words, If
you have Rs. 100,000 worth of stock/cash in your margin
account, you can borrow Rs. 200,000 of stock to sell
short.
To sell a stock short, you must borrow stock. To
initiate a short sale, you simply call up your broker
and ask to sell short a specific number of shares of
your selected stock. Your broker then checks with the
Margin Department to see whether the shares are
available or can be borrowed. If they are available, the
brokerage borrows the shares, sells them in the open
market, and puts the proceeds into your margin account.
To close out your short sale, you tell your broker that
you want to buy the same number of shares that you
shorted. The broker will purchase the shares for you
using the money in your margin account, return the
shares and close out the short sale transaction.
While your short sale is outstanding, your account will
be charged interest against the value of the short
position. If the stock you shorted goes up in price, or
the value of the stock you are using as collateral goes
down in price, so that your collateral is less than the
"maintenance" requirement you will be required to add
money to your margin account or buy back the stock that
you sold short. You must also pay any dividends issued
by the company whose stock you sold short.
Why Sell Short?
The two primary reasons for selling short are
opportunism and portfolio protection. Occasionally
investors see a stock that they believe has been hyped
to a ridiculously high level. They believe that the
stock price will fall when reality replaces the hype. A
short sale provides the opportunity to profit from the
overpriced stock. Short sales are also used to protect
an investor's portfolio against a market downturn. By
shorting stocks that the investor believes will fall
sharply when the market as a whole falls, investors can
help insulate the value of their portfolios against
sudden market drops.
Short selling is also used to protect portfolios against
erosion due to a broad market decline. Short sellers
make money when stock prices fall. An investor can
diversify a long portfolio by adding some short
positions. The portfolio will then have positions that
make money both when prices rise and when they fall.
This reduces the volatility in the portfolio's returns
and helps protect the value of the portfolio when prices
are falling.
By shorting carefully selected stocks that are priced
near their peak but that will fall sharply if the market
falls, an investor can use the profits from the short
sales to help offset losses in his long position to
protect the value of his portfolio.
Short selling just like long buying is essential for
proper functioning of the stock market. It provides
essential liquidity which in turn leads to proper price
discovery. |
