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HOME / KNOWLEDGE CENTRE / ARTICLE DETAILS

Technical Trader
Investment Stretegies
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Traders swing both ways
18:45 Minutes | Uploaded on 13 Jan 2009

Traders swing both ways

If there is one brahmastra in the trader's arsenal, it is his ability to go short. Taking that analogy further, a stance to only go long and not short would be like going to war leaving half your weapons home. Certainly not something that is advisable, unless of course you are looking to be a martyr.

You must agree with the adage that the trend is your friend. If you suffer from an allergy to going short, then you must be specialist at wringing your hands in dismay. What else can you do when the market swings downwards, as it so often does?

What is Short Selling?

“Buy low, sell high” is the goal of both short selling and long buying in shares. A short sale reverses the order of a typical stock purchase: The stock is sold first and bought   
Just as a buyer buys in anticipation of prices going up so he may sell at a profit, a short seller sells in anticipation of prices going down so he may buy the shares back at a lower price. The difference is his profit. If you look closely, in both the cases the shares have been bought low and sold high. The only difference being that in short selling, you reverse the order of the transactions.

Why sell short?

The two primary reasons for selling short are opportunism and portfolio protection. Occasionally we see a stock that we believe has gone up too high too fast. Or we may see a stock struggling to get past a strong resistance. Taking a short position is the only way we can profit from both these situations.

Short sales are also used to protect a portfolio against a market downturn. Short sellers rake in the moolah when stock prices fall. So when we think prices are going to fall, we diversify a predominantly long portfolio by adding some short positions. This way the portfolio will have positions that make money both when prices rise and when they fall.

We then use the profits from the short sales to help offset losses in the long positions. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling.

In defence of the short

Oh! We can almost hear long-termers hiss and boo at the suggestion that short-selling is a nifty portfolio management tool. Don't listen to them. In the long term we are all dead, remember.

They'll tell you that there is no need to short. They'll tell you not to worry about short-term fluctuations in the market. But the point is that most bear markets start with a tiny innocuous intra-day blip that grows and balloons. And before you know it the bears are on the rampage, tearing your portfolio to shreds.

Why sit through a correction where your portfolio has the potential of losing, say, 10% of its value when you could possibly generate a positive return during the same period? Then, when the market turns up, you can get back to the long side and participate in the next leg of the bull market. It does sound like a smart thing to do, doesn't it?

Acting and reacting

But does that mean we react to every intra-day blip that pushes down prices. God! No. That's a sure-fire, time-tested, quality-checked, guaranteed method of committing financial hara-kiri. As is the case with every trade, even a short call is put out only if the risk-to-reward ratio makes sense.

That brings us to the other thing that the long-termers would make noises of disapproval over. The risk in a short trade.

A short could turn into a long sad story

Short-selling stock is an extremely high-risk transaction. The potential gains are limited while the potential losses are unlimited. That's right. Losses tend to infinity!

How? The potential gains are limited to the size of the short sale. The lowest a stock can fall to is Rs0.50 (normally even the rottenest of shares manage to find a stray quote at Rs0.50). So it costs next to nothing to buy back the shares and close out the short sale. In this case, the profits almost equal the outlay on the original short sale, excluding transaction costs.

The potential losses however are unlimited because a stock can keep going up in price indefinitely. Imagine if you had gone short on 100 shares of Infosys Technologies in the IT bull run or say BHEL in the last bull run. Now that you have imagined what that would feel like, it's best you put it out of your memory. That is the kind of stuff nightmares and horror films are made of.

Down on an up

The other risk with taking short positions is that stock prices tend to rise over time. Betting whether a stock's price will go up or down is not like flipping a coin. (Thank God! Or we would be out of a job.) The odds are not even. Over the long term, stock prices on average do tend to trend up.

Also, the reason most people buy shares of a company is because they expect the company to make profitable investments that will make the value of their stock go up. (We do know of a few who buy stocks so that they can use the loss as a tax hedge. Guess there is no better place for that kind of service than the stock market.) Betting that a stock will fall in price is betting against the trend. It does happen but the odds are against it.

So to keep a long story short, short selling can be a very profitable strategy to play the downside, it comes with so much risk that the losses could wipe you out of home and hearth if not handled with discipline and the right kind of tools. Like stop losses. But that is a story that has already been told over and over again.

If you are all charged to trade now, log in to your trading account with Sharekhan now and start trading.

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