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Want to profit from declining share price? Try short selling

Short sellers subvert the famous investing adage “buy low, sell high.” Instead, they bet on plummeting share prices.

International business tycoon Elon Musk, known for his big bets on new age technologies, just spent $10 million in buying shares of Tesla – the company he founded to build electric vehicles. The move was an assertion of his faith in his company’s ability to make profits – something that has eluded it in its short history of 15 years.

It was warranted by the short sellers betting against the electric carmaker.

And Tesla is not just a one-off example of a company getting edgy on account of short sellers. Quite a few other big names including FitBit and Shopify are staring at a similar situation.

But why so?

To understand that, we first need to learn what short selling is.

When we invest in the stock of a company, we do so with the hope the company will make profits and its stock value will rise. We generally hold it for it long term and expect to earn a profit from the price rise when selling it.

But not everyone goes for rising stock prices. A few daring traders bet on declining stock prices too through a process called short selling. This is how it works – they borrow shares from stock brokers and sell them in the hope that the share price will plummet in the near term. Once that happens, they buy back the shares at a lower price. They pocket a profit from the difference in the selling and buying price.

Here’s a simple example to elucidate it:

The current stock price of AB Company is Rs.1000. Expecting it to decline in future, as a short seller you sell 50 borrowed shares for a total of Rs.50, 000. When the price dips to say Rs.800, you buy back those for Rs.40, 000. Thus you make a profit of Rs.10, 000 (Rs.50, 000 – Rs.40, 000).

Contrary to expectations, however if the share price rises one suffers losses and is still obliged to pay the brokerage, which is the fee charged by the broker. So if the share price rises, to say, Rs.1200 you are forced to buy back the shares for a total of Rs.60, 000. In that case you lose Rs.10, 000 (Rs.60, 000 – Rs.50, 000).

A real life example of it would be hedge funds in the US betting against the housing market through short selling anticipating the subprime crisis circa 2008,. Remember the movie “The Big Short”?

Short selling can also be for commodities and futures.

What makes short selling unpopular?

Truth be told, it is not very popular on Wall Street since short sellers essentially take a bearish stance (a bullish stance is one in which investors buy stocks predicting its value to rise and a bearish stance is one which is just the opposite). This puts investors at loggerheads with company owners since they are betting against the entity’s performance with the belief that the overpriced shares would correct soon.

In the wake of subprime crisis resulting from the bursting of the housing bubble in 2008, short selling of financial stocks was even banned in Australia, Canada and many European nations because it was felt selling stocks en masse would hurt stock prices further and negatively impact economic growth. In fact, by making price declines steeper, the process actually makes it difficult for companies to raise capital. This is exactly why Elon Musk bought shares of his own company – to establish his faith in the company in no uncertain terms and scare short sellers.

Apart from the above logic, losses incurred in short selling can be massive. It is definitely for the fainthearted; only shrewd market watchers can cash in on it. Such sudden selling and buying of shares can make markets volatile too, another reason why they are unpopular and are often monitored closely.

Is it really bad?

Well not quite so. Despite many claiming it’s purely guided by a profit motive, there are quite a few advantages of short selling. Foremost among them is price discovery. Without short sellers, the price of a security may not reflect its true value. With only buying interest, manipulated by promoters, their prices could end up being inflated. However, short sellers help in price correction of overpriced securities.

Another crucial benefit of short selling is its ability to infuse liquidity into the market, which is all about being to buy and sell assets quickly and easily.