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Friday, January 6, 2017

Is Selling Short riskier than Going Long?

'Selling Short' is a strategy when you are feeling bearish. You expect that the stock market as a whole, or a specific stock you may or may not hold, will be falling lower. So, you decide to sell first - and try to buy later at a lower price.

Shorting usually means selling some thing that you do not already own. You obviously can't own the index. But you can buy/sell an index in the F&O segment or buy/sell an index ETF.

How can you 'short sell' a stock that you don't own? By borrowing the stock - either from a friend, or from your broker. You may need to pay a 'margin' amount for doing this.

'Going long' is the opposite of 'selling short'. You are feeling bullish, and expect the stock market or a specific stock will be rising higher. So, you decide to buy first with the expectation of selling at a higher price in future.

Most small investors take the 'going long' route. It is an easier concept to understand and implement. But it works best when a stock or an index is in a bull market.

A stock or an index doesn't move up in a straight line. There are periods when there is an up move, followed by periods of correction. Such corrections provide opportunities for adding more. The tactic is called 'buying the dip'.

'Selling short' works best when a stock or index is in a bear market. Every fall in a stock or index is followed by periods of correction when there is a price rise. Such corrections provide opportunities for selling more. The tactic is called 'sell on rise'.

Now that you know all about 'selling short' and 'going long', which strategy should you follow? It should depend on the strategy with less risk. So, which is the less riskier strategy? This can be explained with examples.

Let us say you buy a stock at Rs 50. The price rises to Rs 70 and then corrects to Rs 60. You 'buy the dip'. The price rises to Rs 90 and then corrects to Rs 80. You 'buy the dip' again. This time the stock price touches Rs 100 and you decide to book profit.

But making money in the stock market is never that easy. What if the stocks price drops to Rs 40 after you bought it at Rs 50. Will you 'buy the dip' by 'averaging down' or sell the stock at a loss? 

Many small investors lose a lot of money when they 'average down' by buying a stock as it falls. Theoretically, the stock's price can fall to zero, and you can lose your entire investment.

A better strategy when a stock or an index is falling is to 'sell short'. But there is a problem here. What if you ' short sell' the stock at Rs 50, expecting it to go down, but it rises to Rs 60? Your friend or broker - who loaned the stock to you - may want the stock back.

You have two choices. Buy back the stock at Rs 60 and bear the loss of Rs 10 per stock. Or, you can keep your short position 'open' by paying an interest (called 'margin') and hoping that the price will eventually fall.

But the price keeps on rising, till you are forced to buy back at a much higher price and sustain a considerable loss. Theoretically, the stock price can rise to infinity, which means your loss can be infinite.

That may not happen in real life, but it isn't impossible for a Rs 50 stock to rise to Rs 500 (a 'ten bagger'). By 'going long' on a Rs 50 stock, you can lose Rs 50 at most (unless you 'average down' - in which case you can lose a lot more). By 'selling short' a Rs 50 stock, you can lose Rs 450 if the stock rises to Rs 500!

By applying a proper stop-loss to what you buy or sell, you can limit how much you can lose on a particular transaction. However, the fact remains that 'selling short' involves a greater risk than 'going long'.

(In a bear market, a less risky strategy is to 'short' a stock you already own. That means no borrowing and no paying of 'margin' money. Say, you decide to sell Tata Motors at Rs 500 - hoping to buy it back at a lower price. But the price moves up to Rs 550. You don't lose any money because you already owned the stock. But you do lose the opportunity of making an extra Rs 50.)

Read this article in investopedia.com to learn more.