Analyst Insight
Introduction
Over the last five years, the local equity markets have seen the rise of retail traders who actively engage in the frequent trading of stocks over a relatively small time period. The profit mechanism that most investors are familiar with is that of taking a long position on stocks; whereby investors buy a stock in anticipation of the stock price appreciating in the future and as such benefiting from capital gains. However, there exists an alternative approach from which investors can benefit which is shorting a stock. There has been growing interest locally in the short selling of stocks, and as such, we believe that a conversation around it would be useful.
What Is Shorting?
Shorting refers to the process where a trader borrows shares from a broker and then sells them with the hopes of the stock price falling shortly after purchase. If the price of the security does fall, the trader is then able to buy the shares at a lower price and then return the security back to the broker. The profit generation lies in the actual price of the stock falling after the short trade was executed. So, for example, if you wish to short Company ABC Ltd, you borrow 10 shares from your broker at a price of $10 each, which gives a total value of $100 after you sold them. If after selling, Company ABC’s stock price fell to $5, you can then purchase the stock at $5 per share which gives a spend of $50( not inclusive of commission fees, GCT, and cess fees) and return the shares to the broker. In so doing it would have enabled the investor to make a profit of $50.
Why Short A Stock?
The question, that may arise in the minds of many, is why short a stock?. The primary reason investors short stock is to make money when there are doubts about the performance of a company over the near term. As opposed to the traditional equity play that the average investor is accustomed to, whereby they profit from the company providing solid performance, shorting enables investors to profit from the downturn in a company’s performance. As such, shorting can be seen as a tool that provides investors with a widened profit-making playbook. Shorting a stock also can be used as a hedge. So, for example, you own shares in company ABC Ltd and have doubts about its near-term performance, but don’t want to sell your shares. In this instance, you could continue holding your shares for the long-term while you short the stock, buying back in at a lower price when the stock’s value falls. The goal here is to offset the losses of your long-term holdings. The question, that may be asked is why would brokers be willing to lend their shares to clients, from the perspective of the broker it allows the broker to benefit from fee income from the transaction. These fees are inclusive of the interest that is earned, as well as the commission fees. Additionally, it allows the broker to facilitate the shorting of stocks that it could not short readily given the regulatory environment that may inhibit them from executing such trade proprietarily.
Developing A Shorting Strategy
To be successful at shorting a clear strategy must be developed that is grounded in deep analysis and is customized to the investment objectives of the investor. Generally, across the global markets, the three commonly used strategies that exist as it relates to short are fundamental analysis, technical analysis and thematic analysis.
Fundamental analysis: This refers to analyzing a company based on its financials and dissecting from its financials if there is a possible pullback of the stock, due to missed earnings or a financial downturn in the Company. As such if one expects a financial downturn in a company, one can also expect a negative reaction from the market and as such, this would be indicative that this stock would be a good target for shorting.
Technical Analysis: Historical trading patterns of a stock’s price movement can also help you determine if it’s on the verge of a downtrend. Also, another potential sign of a seller’s market is a stock that’s been falling through a series of lower lows while trading at higher volumes. Another is a stock that’s rebounded to the upper range of its trading pattern but appears to be losing steam.
Thematic Analysis: This approach involves betting against companies whose business models or technologies are deemed outdated or companies who are expected to have legal and regulatory troubles based on their business operations or ongoing legal proceedings. This can be more of a long game but can pay off should your prediction prove correct.
The Risks
As with all investment decisions, there are underlying risks involved and as such shorting is the same. When you buy a stock, your downside is limited to 100% of the money you invested. But when you’re shorting a stock, its price can keep rising, meaning that theoretically, the amount you’d have to pay to replace the borrowed shares is limitless. Additionally, if the value of the collateral in your margin account drops below the minimum equity requirement usually 30% to 35% of the value of the borrowed shares, depending on the firm and the securities you own your brokerage may require you to deposit more cash or securities to cover the shortfall immediately.
Conclusion
Shorting a stock is essentially, rooting against an individual company or the entire market, akin to swimming upstream in a heavy tide. The practice of shorting requires a clear-cut strategy that is rooted in strong analysis and market understanding. With that said, if done correctly it positions investors to widen their profit playbook, as it allows profit generation during the downturn of a company.
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