Short-selling is defined as selling shares you do not own (i.e. borrowing shares) at a higher price in order to buy them back again at a lower price, thus pocketing the difference. It has become increasingly popular with investors due to the availability of products in the market which allow investors to do so.
The media has also recently reported on prominent short-selling firms such as Muddy Waters and Glaucus Research, which seek to profit from short-selling overvalued companies and then buying back their shares cheaply.
Short-selling, however, is a risky and dangerous undertaking which should be discouraged, for the three reasons below.
Limited Upside, Unlimited Downside
When you short-sell, the assumption is that a company is overvalued or too expensive and that the share price would fall so that you can buy back the shares more cheaply.
However, the maximum that a share price can fall is 100% (from current share price to zero), whereas, in theory, there is no limit to how high the share price can rise if a business continues to do well. This creates a situation where the upside is limited, while the downside can be potentially unlimited as the investor would be relying on borrowed money.
If the investor buys shares to hold for the long-term, there is no time pressure involved as he simply has to wait for business growth to be reflected slowly in the stock price.
For short-sellers, though, there is constant time pressure as the shares are borrowed and thus may have to be returned. Also, there is no guarantee that any overvaluation can be corrected and it may persist for the long-term, while extrinsic factors may also cause the company to perform better than expected.
Human beings are generally geared towards improvement and growth, and short-selling goes against this fundamental human principle. The investor, therefore, has to be either unusually shrewd or prescient when he short-sells.
Cost And Availability Of Borrow
Investors should also not forget that the ability to short-sell is also predicated on the ability to obtain “borrow” from brokers. If no shares are lent out for a particular security, he would not be able to short-sell.
Generally, shares on loan are only available for the larger, liquid names which are extensively covered by sell-side analysts. Granted that 85% of all recommendations are for a “Buy”, this also makes it more difficult for a short-seller to profit. The cost of borrowing shares may be around 3% to 4%, which is a constant expense for the investor, and if a company declares a dividend, the short-seller has to pay the dividend to the owner of the shares (i.e. the person who lent out his shares).
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