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Dangers of short selling

Dangers of short selling
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First Published: Tue, Aug 30 2011. 08 57 PM IST

Updated: Tue, Aug 30 2011. 08 57 PM IST
Are you someone who believes that short-term market volatility can indeed present some good money making opportunities? Do you tune in every day to what experts are saying about “going long or short” with stop loss target levels on indices? Given the dismal state of economic affairs the world over, be it sovereign debt or inflation, negative sentiment is dictating equity markets rather than fundamental value. For some this presents a window to make money by “shorting” stocks believing that the sentiment can make prices go even lower.
Short selling refers to the tactic of selling a stock without owning it, with the view that the price is likely to fall further and, hence, there is profit to be made by buying it back at a cheaper price. In Indian equity markets, short selling is typically undertaken via the futures and options route since short (sell) positions in the cash markets can be held only intra-day.
Intra-day or not there is an inherent risk in adopting a short selling strategy. Firstly, let’s be clear that it is trading and not investing and to that extent it carries the risk of timing and speculation. Moreover, the discipline required to see it through goes against an investor’s natural instinct and makes the position riskier. It’s no secret that the recent demise of large financial institutions, including Lehman Brothers and Bear Sterns, was speeded up by the fast and sharp decline in their stock prices, which in turn were aided by large short selling bets (shortly thereafter, US Securities and Exchange Commission halted short selling in financial companies). It is rumoured that those who placed these bets made profits of many million dollars. Says G. Maran, executive director, Unifi Capital Pvt. Ltd, a portfolio management service and securities firm, “The impact of short selling is often exaggerated. While large short positions can expedite events such as in the case of Lehman, they can’t bring down the fundamental value of a company.”
While it’s true that in such examples, the profit made can be multifold, you have to be a seasoned trader and also have the ability to take the risk of stock prices not moving in the direction you expect. It’s also true that the loss, if the scenario you envisioned doesn’t play out, can be manifold and hard to digest. Market volatility itself adds to risk in an investment, why make it worse by taking on additional risk?
Here is what makes short selling intrinsically risky and why retail investors should stay away from it.
Historically, equity markets have gone up rather than down
Short selling as a strategy takes advantage of downward movement in prices. Historically though, individual stocks and short-term movement aside, equity markets, both domestic and global, have moved upwards. For example, the S&P 500 index has increased at 6% compounded annual growth rate (CAGR) since 1961 despite short corrections—the longest correction lasted for one year and nine months. Back in India, the Sensex has increased at 17% CAGR since 1981. So as long as the economy is growing and individual companies are following suit, stock markets get over corrections and resume an uptrend. Thus, if we agree that the direction of markets is generally bound upwards, then holding on to a short position for a long time is betting against the historical trend of a market and can be very risky. Says Gaurav Mashruwala, a Mumbai-based financial planner, “If you take a short position you assume that the market will fall, if your call goes wrong you stand to lose a lot.”
Getting the timing right is difficult
As mentioned above, this kind of a strategy involves trading and requires a degree of speculation as to the market direction. While buying a stock, an investor bases decisions on fundamental analysis of future profitability. So if the analysis downgrades future profitability you simply exit the stock. Short selling on the other hand would mean that for a stock on which you have a negative outlook, you are selling it without owning. Says Maran, “When taking on a short position not only should your view be right but also it should be the right time. So if you are assuming that the stock price will decline, it must happen in the time you want it to.” And this is difficult. So if the stock price goes up after you have short sold or if you short sell too soon and the price takes longer to correct (John Maynard Keynes famously stated with respect to speculation, “Markets can remain irrational far longer than you or I can remain solvent”), then in both scenarios you are likely to take in a loss, not because your call was wrong but because the timing of your call was wrong. Maran adds, “In some cases operators can also manipulate stock prices and keep them higher much longer than intrinsic value suggests.”
Possibility of unlimited loss and margin costs
Theoretically, one stands to make only limited profit on a short sell with chances of unlimited loss. This happens because if your call on the short sell doesn’t play out then the loss on the transaction depends on the rise in stock price before you are able to close the short position. And theoretically, the stock price can rise to any level, whereas the gain is limited since the stock price cannot go below zero. Maran says, “There is no cap on an upside that a stock can achieve, then if you hold a short position the problem is when you exit if the price is going higher.” This is not to say that every short sell carries the risk of an unlimited loss, but simply that if your judgement is incorrect, the loss can be very high as the stock price may shoot up.
In the Indian capital markets, a short position in stocks can be carried forward only in the futures and options segment. This means that margin money (initial and mark to market margin) has to be maintained. This is an additional cost for the trader and as the stock price increases, not only is the trader’s position loss-making, margin money requirement also increases. Additionally, margin requirements are not fixed and increase with higher stock volatility. Says Maran, “During 2008 when markets declined, many could not carry on their short positions because of high margins and losses that had to be paid. One doesn’t have unlimited money.”
Trading discipline
Says Vinod Sharma, head (private broking and wealth management), HDFC Securities Ltd, “A typical trader would be more than willing to buy when the markets are in a bullish mode. But when it comes to a bearish market, only 20% of the traders would think of going short.” This happens because, trading, whether it is going long or short, requires a great deal of discipline. One has to define strict stop loss levels and be willing to take a loss if their call is wrong. Says Rahul Rege, business head (retail), Emkay Global Financial Services Ltd, “Investor psyche is such that if you buy a stock and it is showing losses you will have the patience to hold on for many months or years before exiting. But the same doesn’t hold for a short sell, here one tends to get restless and move out of the position fast thus most of the time it doesn’t work out.” Without the mental discipline not only will profits be restricted but also the acceptance of taking a loss is not there and that increases the probability of having to incur higher losses. Says Sharma, “A trader can make money regardless of market direction. But this requires different skill sets and a fair understanding of the options. When they (traders) do short sell, it is usually a small trade (amount) and these too are infrequent. Very few traders have the mental framework to short.”
Moreover, holding on to a short position for a long time means you will have to re-enter a new contract every month (when the futures and options contract expires), this has additional costs attached as the only way to do so is by first booking a loss on the previous contract and then entering a new contract.
Illustration by Shyamal Banerjee/Mint
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First Published: Tue, Aug 30 2011. 08 57 PM IST