Short Selling: Meaning, Advantages, Facts and Risks Involved

Short selling is the traditional approach to trading for making a profit out of it by "buying low and selling high". In other words, this strategy is about expecting the stock prices to decline and then capitalising on this prediction.

This trading strategy is well-suited for experienced traders because while this trading strategy has many benefits, there are limitations too.

People employ the short-selling strategy to earn profits within a shorter timeframe by making a quick sale. In this, traders with a bearish view borrow shares from the market and sell them off immediately at the prevailing price. When the price drops, they can buy them back at a lower price and close their short position after making quick profits.

Factsheet of short selling

Detailed below are noteworthy features of short selling:

• While institutional and retail investors can short-sell, the sellers are not the share owners. They borrow it from a different owner.
• With short selling, the seller takes advantage of a price drop. They shall face losses if the price rises.
• Generally, short selling occurs in a bearish market when the chances of a price drop are significantly high.

Benefits of short selling

Listed below are the benefits of short selling:

• Short selling ensures liquidity in the market resulting in lower stock prices, improves bid-ask spreads, and helps in price discovery.
• The only requirements that a person needs to execute short selling are margin maintenance, commissions, and dividend.
• Exposure to each of the long and short positions reduces portfolio volatility. Moreover, there remains a probability of substantial gains if the prediction of a price decline comes true.

Drawbacks of short selling

Here is a list of the problems of short selling:

• Financial experts consider short selling to be quite volatile, and there remains the probability of losses without a limit. There is a high risk associated with this strategy because stock prices change rapidly.
• Lenders may recall the borrowed stock at any time. Moreover, short sellers have minimum control over the price required to cover their position.
• Traders must have a margin account and pay a certain amount to make short sales.

If you are an experienced trader and looking to explore the short selling strategy, it is vital to have a Demat account. Bajaj Financial Securities Limited stands as a reliable choice for investors seeking to open a Demat account with abundant features and complete safety.

Why sell short?

Short selling is a strategy used in trading for two main reasons. First is predicting price movements. A trader may predict that the price of a certain security will decline in the future; and so if they are wrong, they will have to buy the shares back higher, at a loss. However, this strategy involves higher risks, and it's crucial to be cautious and well-informed before implementing it.

The second reason for short selling is hedging, which involves selling short to hedge a long position. This helps lock in profits and limit potential losses.

Example of short selling for a profit

Let’s say you believe that the price of a particular stock is going to decline. You borrow shares of that stock from your broker and sell them at the current market price. Later, when the price of the stock falls as expected, you buy back the shares at a lower price and return them to your broker. The difference between the selling price and the buying price is your profit.

Example of short selling for a loss

Conversely, if you short sell a stock and its price rises instead of falling, you may incur a loss. For instance, you borrow shares of a stock from your broker and sell them at the current market price. However, if the stock’s price increases instead of declining, you will need to buy back the shares at a higher price to return them to your broker. The difference between the buying price and the selling price represents your loss.

Example of short selling as a hedge

Short selling can also be used as a hedging strategy to protect against potential losses in an existing long position. For instance, let’s say you own shares of a company and anticipate that its value might decline in the near future due to certain factors. To hedge against this potential loss, you can short sell an equivalent number of shares in the same company. If the stock’s value does indeed decrease, your short position will offset some or all of the losses incurred on your long position.

Please note that these examples are for illustrative purposes only and do not constitute financial advice. It’s important to thoroughly understand the risks associated with short selling before engaging in such transactions.

What is Naked Short Selling?

When an investor shorts a stock without borrowing or making any arrangement to borrow it, it is referred to as a naked short sell. The trader will not be able to tender shares to the buyer if he/she fails to borrow them before the clearing period. He/she must close the position or borrow more shares. Until and unless he/she does that, the trade will be seen as ‘failed to deliver’.

Naked short selling is not allowed in many countries, including India, because it disrupts the regulations regarding demand and supply. It can create high market volatility if it is carried out in large quantities.

Can a person short-sell in delivery trading?

Intraday trading is allowed in the Indian market, but if a trader sells and doesn’t deliver the shares, his/her trade becomes a ‘short selling in delivery’. If a client purchases shares, he/she must pay the full amount and take delivery through his/her Demat account.

If the sale of shares takes place with delivery in mind, then one must deliver these shares to the exchange. In case of a failure, this delivery trade will become a short sell.

SEBI (Securities and Exchange Board of India) has defined short selling as selling a security or a share that a seller does not own. Experienced traders and seasoned investors engage in this advanced trading strategy. This is because short selling has a high risk-to-reward ratio. In other words, traders have chances of earning high profits and incurring great losses as well.

Short selling technique is not for naive traders, who are not aware of the inherent risks in the activity. Only those traders having detailed knowledge of stock market dynamics should practice short selling.

By carefully considering the strengths and risks of short-selling, investors can make informed decisions. If you are an experienced trader and would like to leverage this opportunity, open a Demat account with Bajaj Financial Securities Limited now and start trading.

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