In short selling or shorting stocks, you borrow and sell the shares with the hope of buying them back at a lower price, which you then return to the trader you borrowed from and pocket the difference. The risk is glaring at you right there. Here are a few explanations for why you should never short a stock unless you have the right expertise to back your calls.
Short Selling Example
Let us suppose; you believe that company XYZ is overvalued and it is only a matter of time before the stock price corrects itself downwards. You decide to borrow 5 shares of company XYZ from your broker. Now two things can happen.
One is your call turns out to be a sound one and the XYZ stock prices drop in the near term to Rs.80, and you had sold the stock at Rs100 per share. Now, you pick up 5 shares of XYZ at Rs.80 each, return them to your broker, and pocket the difference of Rs.20 per share.
In the second scenario, if the price of XYZ stock rises to Rs150, then you will have to repurchase the 5 shares at the higher stock price to repay your broker. In the real world, the stakes are much higher, and the risk equally great.
When famous investors short sell, it often makes headlines potentially benefiting them further, sometimes unleashing market disruptions, but it is not for every investor to short sell.
Difference Between Shorting And Going Long
Shorting is way riskier than going long or buying a stock and here’s why. When you buy a stock or go long, the most you will lose in the worst-case scenario that the stock price never recovers again is your initial investment. But when you are shorting, the downside risk is unlimited if prices you borrowed at do not decline as you had expected and instead they begin to climb up. What you can do in such a situation is, to buy back at the prices closest to the one you purchased to return it to the lender and stop your losses there.
Example of Short Selling Gone Wrong
In November 2015, an American investor by the name of Joe Campbell shorted stocks worth $37000 on a pharma company, KaloBios Pharmaceuticals. Much to his shock, he found out the following day the shares rose 800% after a major newsbreak. Things were made worse when his broker failed to cover the position in time, and he was left to raise money to cover his losses.
Being Careful In Shorting Small-caps
One lesson investors learned from the incident above was that they needed to be careful while shorting stocks, but they need to be doubly cautious and perform due diligence in shorting small-cap companies. With small caps, since the prices are volatile, one may make the mistake of undermining their growth potential and end up making losses like Campbell.
Need To Have Enough Capital To Cover The Losses
When large hedge funds or investors with deep pockets engage in short selling, they are likely to have a capital cushion to absorb the losses when stock prices rise, in most cases. If an increase in stock prices is disproportionate to market expectations, it can hit novice investors or investors with relatively less capital cushion, particularly hard, sometimes wiping away all the investment.
Following Only Well-known Investors Can Be A Bad Idea
When a relatively big investor or hedge fund short sells, does not mean the smaller investors need to short it too, to benefit from the potentially spiralling prices. It may not always work out since these short positions may be a one-off position that big investors choose to take. They may not be doling out all their investments in short selling.
Need Real Expertise
It is not that there aren’t short selling opportunities available out there. What a lot of new investors may not realise is it is hard work to pick right shorting opportunities. Stock trading requires trend analysis and deep-end technical research to track a company’s performance. Other factors like valuation, price and years of investing experience are also crucial to NOT go wrong with short selling. In conclusion, you need good analysts by your side before making quick selling decisions for profits.
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