Short Selling: A High-Risk Game of Pessimism
On January 25th, Hindenburg Research released its 32,000-word report accusing the Adani group of stock manipulation and accounting frauds, Hindenburg Research defines themselves as an Activist Short Seller. This brought Hindenburg Research and Practice of Short selling into the Spotlight. Let us try to understand the practice of short selling.
In conventional trading, a trader will get profit as the value of the stock appreciates over time which can be sold at a higher price to earn the profit, this is also referred to as long trading, contrary to this in short selling trader will get profit if stock depreciates and will have to face loss if stock price increases. However counterintuitive it may sound counterintuitive but it works, let’s see how.
In Short Selling the trader will borrow the stock from a lender and will sell it when the price is high, the investor will buy it back when the price goes down and the difference of this will be a profit for the trader. For example: Suppose the stock XYZ currently values at 100 Rupees, on selling it trader will get 100 rupees, After sometime stock price falls to say 70 rupees, the trader will buy it back and give the stock back to the lender. Here the trader gets a profit of 30 Rupees. You might be thinking that what will the lender get in this case, Lender gets interested in the value of the stock from the trader along with this trader has to deposit a security which is referred to as a haircut which typically ranges from 10-20% of the value of lending.
Short Selling is a high-risk practice that comes with a risk of infinite theoretical loss. This may again sound strange so let’s take an example to understand. Suppose Stock is valued at 100 Rupees and the trader borrows it from the lender for a security deposit of 20 Rupees, Now if the stock price depreciates trader will get a profit and the maximum possible depreciation is that price falls to zero, on buying it back at 0 price investor will get a straight profit of 100 rupees on investment of 20 rupees (ignoring interest rate for simplicity) which means 400% profit. Now, look at the case when the price of stock increases and the maximum it can increase is that the stock value became very large i.e infinite, now on buying that stock at an infinite price will lead to a loss of infinite i.e ( Infinite -100 = infinite) and an infinite loss on 200 rupee investment i.e infinite % loss.
In comparison to this long trading has a limit of 100% loss i.e stock loses all of its value and a theoretical possibility of infinite profit i.e stock value reaches infinity.
Short trading comes with other risks such as market squeeze where traders are forced to sell the stock due to a sudden sharp jump in stock price and selling of stocks will drive the price even further, this can make traders face huge losses.
In conclusion, short selling allows traders to make a profit in pessimistic conditions or during a crisis as we saw in the 2008 financial crisis, but it comes with its high risks of very high losses. Short selling also impacts the markets by increasing market volatility and Short sellers need to maintain a close look at market conditions to make profits.
