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Short selling may lead to unlimited losses

business Updated: Sep 03, 2011 00:06 IST
Lisa Pallavi Barbora

Are you someone who believes that short-term market volatility may present some good money-making opportunities? Given the dismal state of economic affairs the world over, be it sovereign debt or inflation, negative sentiment is dictating equity markets rather than fundamental value. For some this presents a window to make money by "shorting" stocks believing that the sentiment can make prices go even lower.

Short selling refers to the tactic of selling a stock without owning it, with the view that the price is likely to fall further and, hence, there is profit to be made by buying it back at a cheaper price. In Indian equity markets, short selling is typically undertaken through the futures and options route since short (sell) positions in the cash markets can be held only intra-day.
However, there, is an inherent risk in adopting a short selling strategy. Here is what makes short selling risky and why retail investors should stay away from it.

Historically, equity markets have gone up
Short selling as a strategy takes advantage of downward movement in prices. Historically, individual stocks and short-term movement aside, equity markets, both domestic and global, have moved upwards. So, holding on to a short position for a long time is betting against the historical trend of a market and can be very risky. "If you take a short position you assume that the market will fall, if your call goes wrong you stand to lose a lot," said Gaurav Mashruwala, a Mumbai-based financial planner.

Getting the timing right
As mentioned above, this kind of a strategy involves trading and requires a degree of speculation. If the stock price goes up after you have short sold or if you short sell too soon and the price takes longer to correct, then in both scenarios you are likely to take in a loss, not because your call was wrong but because the timing of your call was wrong.

Unlimited losses
Theoretically, one stands to make only limited profit on a short sell with chances of unlimited loss. This happens because if your call on the short sell doesn’t play out then the loss on the transaction depends on the rise in stock price before you are able to close the short position. However, not every short sell carries the risk of an unlimited loss, but simply that if your judgment is incorrect, the loss can be very high.