What is Short Selling? Advantages and Disadvantages

Short selling is the sale of a stock that is not owned by the seller, but it was lent by the brokerage firm on a promised to deliver the stock back to the broker. It is the selling stocks or shares that are not owned by a seller and is not in his demat account. The brokers lent the shares to the seller with a promise that they will be delivered back to the broker at the time of settlement.

The equity is sold and the proceeds are credited to the seller account and they have to close this position by the day end. If the price of a stock that the seller has sold, he can buy back the stock at the lower price and make a profit. However, if the price of the stock rises, he has to buy it back at the higher price, and which will incur a loss.

Advantages

• Provide liquidity to the markets which may lower prices of stocks, improve bid-ask spreads and assist in price discovery
• Ability to hedge an existing portfolio’s long-only exposure and reduce the overall market exposure of a portfolio
• Short selling allows a manager to use capital proceeds to overweight the portfolio’s long-only component of the portfolio
• Exposure to both long and short positions can reduce a portfolio’s overall volatility, and
• The ability to add meaningful risk-adjusted returns

Disadvantages

• Shorting stocks can be inherently volatile. While it is possible for a stock to go to zero, this tends to be a rarity. Stock prices tend to mean revert, and this turn around can be both quick and significant on the back of some event
• While the maximum potential gain on shorting a stock is 1x, should a stock’s price appreciate there is, in theory, no limit to the potential losses from being short
• Short sellers run the risk of borrowed stock being recalled by their broker when the short seller has limited control on the price of covering their position
• Short squeezes, where rapid and significant upward price moves cause short sellers to cover in mass, can push prices against short-sellers
• Borrowing stock can be difficult in less liquid names or if the amount of available stock in the market is limited
  Less liquid stocks may be expensive to borrow, and
• The exchange may limit or ban short-selling during volatile market conditions, such as the GFC when the ASIC banned short selling on concerns about market stability