Question

Write up to a one page, typed (single spacing is fine) essay on the following topic:

When might an investor want to short sell a stock? How is this done? Is this part of a "standard" portfolio? Does it increase portfolio risk?

Answer 1

An investor might want to short sell a stock when there is an expectation that the prices of the stock are highly likely to fall in future. In such a situation the investor will borrow that stock, sell it and then buy the stock back at a lower price to return it the lender from whom the stock was borrowed.

For instance suppose that Mr. ABC is an investor who knows that due to poor macro and micro economic factors the stock of XYZ Company will fall in future. The stock is currently trading at $10 and Mr. ABC strongly believes that this will fall to $6 in next week.

In such a situation Mr. ABC will borrow that stock and sell it immediately at the prevailing price i.e. $10. Next week when the stock price falls to $6 he will buy that stock and return it to the lender. In this case he is pocketing a profit for himself and the quantum of profit = selling price of the stock – buying price of the stock = $10 - $6 = $4.

No, short selling is not a part of standard portfolio. It is used mainly in cases of portfolio in which speculation or hedging is a key and prominent feature. It should be noted that the investor’s bet that the stock price will fall in future might not always happen in the real world and hence the investor is mainly indulging in speculation with the primary intention of making additional profits on a potential decline in a specific security.

Yes, short selling does increase portfolio risk. As mentioned in the paragraph above short selling is mainly used for the purpose of speculation and this brings in additional risk elements with it. The risk of losing money gets amplified in case of shorting a share when compared to the situation in which an investor originally buys the share i.e. taking a long position on that share. In case of a long position the investor will stand to lose only the money that they have invested. So if a person has invested $100 in buying a company’s shares then the loss will be limited to $100 only. However in case of shorting a share the investor stands to lose an infinite amount of money on a theoretical basis. This is because a stock price can keep rising forever.