Short Selling

Short selling means borrowing a security you expect will drop in price, then selling it to buy back later at a lower price, pocketing the difference.
Short Selling
3 mins
10-Jul-2024

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.

What is short selling?

Short selling in the stock market refers to the practice of borrowing a security whose price you anticipate will fall in the future and then selling it in the open market. You then buy the stock back, preferably at a lower price, to make a profit. Once the trade is done, the borrowed stock needs to be returned to your stockbroker. The underlying motive of this trading strategy is to buy low and sell high. Traders engaged in short selling expect stock prices to fall in the future and aim to capitalise on this decline.

How does short selling work?

In the financial market, short-selling is based on market speculation and contains significant risk. Typically, only experienced investors and traders can comfortably take the risks and try to benefit from this strategy. In short-selling, a trader first sells the shares they borrow from a broker. These shares are not owned by the trader and are simply borrowed. From this position, the next step is to wait for an anticipated drop in the share price. This is because the shares have to be bought back to return to the broker and close the open position.

In this strategy, traders benefit from the price difference between the buying and selling price of stocks. However, the shares are sold first, and traders wait for a price drop to buy them back. As mentioned earlier, there always exists a big risk that the share price will not drop and may even increase. This can lead to significant losses for traders and investors. In addition to capitalising on speculation, fund managers and investors also leverage short-selling measures to manage the downside risk involved in maintaining a long position on their assets.

One of the specific prerequisites of short-selling is the margin account, which has to be utilised to borrow shares from a broker. In this account, a margin amount must be maintained to continue holding the position. Keep in mind that this only applies to cases where you borrow the stocks from a broker. A margin account is not required when fund managers or investors look to protect a long position from potential losses and downside risks.

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.

What are short selling metrics?

There are two key short-selling metrics that investors and traders rely on to analyse and identify overvalued stocks. These are:

  • Days to cover ratio
    This ratio is used to analyse the interaction of the total number of short stocks and the present trading volume of the share. It can also be expressed as the ratio of short interest to volume. Traders rely on this to understand the demand for a stock, with a high ratio signifying a bearish trend.
  • Short interest ratio
    This ratio helps traders understand the relation between the number of shorted stocks and the number of currently afloat stocks in the financial market. A high short-interest ratio is a possible sign of an impending price decline in the given stock. This also worsens short-squeeze possibilities.

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.

Additional read: What is Equity Market

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.

Risks of short selling

While profitable under the right circumstances, short selling also involves the following risks:

1. Difficulty of timing the market

The success of a short-selling strategy entirely depends on precisely timing the buying and selling of stock. If you delay shorting a stock, there may be a good chance that it has lived out most of its price fall.

2. Potential for unlimited losses

Shorting can lead to losses if stock prices rise instead of falling as anticipated. The potential for loss is infinite since there is no ceiling on how much a stock price can rise.

3. Margin interest

Traders engage in short selling by borrowing from their brokers. They are liable to bear a certain interest on the borrowed stocks and maintain the margin. If you fail to maintain the margin, your broker may ask you to add more funds or liquidate your position, leading to losses.

4. Unwise selections

Short selling involves rooting against companies or the overall market. Selecting the right stocks to short is the key to making profits from a short sale. Choosing the wrong company to short can result in losses for the trader, while others gain with a long position.

5. Risk of short squeezes

Short squeezes happen when traders try to buy back stocks that have been heavily shorted. A sharp rise in the price of this heavily shorted stock prompts traders to buy it back to minimise losses. Each wave of buy back increases the stocks price even further, resulting in greater losses for traders holding onto a short position.

6. Regulations

Short selling is completely legal in most countries, including India. However, market regulators may restrict or prohibit short selling in particular sectors or the entire market to avoid panic and limit selling pressures.

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.

When is short selling profitable?

The short-selling method can be profitable if done right. It is important to be confident about speculation and patient while waiting for the price to drop. When the prices fall, you can profit by buying the security at a lower price than what it was sold at.

Let us take an example of a situation when short-selling can be profitable. Rashmi believes that the stock ‘XYZ’ is overvalued, currently trading at Rs. 100. They expect that when the company declares its financial reports in a couple of weeks, its stocks will decline sharply. To benefit from this speculation, they borrow 100 stocks of the company to short sell them at the current price of Rs. 100. After waiting patiently, when the financial reports are released after two weeks, the speculation turns true, and the stock price falls by Rs. 20 to Rs. 80. At this price, Rashmi repurchases the 100 shares, making a profit of Rs. 20 per share. Their overall profit earned from short-selling, in this case, is Rs. 2,000 as they return the shares to the lender.

In reality, even after reaping a profit of Rs. 2000, Rashmi may have to pay more charges. This includes commissions, borrowed stock interest, and possibly a dividend payment to the buyer of the stock.

In addition to these conditions, if many traders short the same stock, it can cause a shortage of available shares. This would, in turn, raise borrowing costs. However, there is no guarantee of finding buyers and sellers later in the market, even after borrowing.

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.

When does short selling result in loss?

Short-selling can result in a loss when the speculation of an investor does not come true and the price of the shorted stock goes up. What makes this situation worse is that, theoretically, it is possible to lose an infinite amount as the prices can go infinitely high.

In traditional trading, stocks are bought at the market price with the expectation that the price will soon increase when they can be sold for a profit. This is less risky compared to short-selling, as you can only lose to a certain extent. While there is limited risk in traditional trading, there is infinite or unlimited risk in short-selling.

Let us also illustrate the loss-making potential in short-selling with an example. Suppose Aarti decides to invest in the shares of the company ‘MNO Ltd.’. As they expect the stock price to fall from the current value of Rs. 500 per share when the company comes out with its annual financial report in a month, they decide to borrow and short-sell 10 stocks at the current market price. With the announcement of the financial reports, it is also revealed that the company was bought by a bigger and more reputed company, ‘ABC Ltd.’, and will soon merge with it. Despite a not-so-great financial report, this news is received positively by the market, causing a price jump in the share price to Rs. 550. This is a terrible move considering Aarti’s short position at Rs. 500. Nevertheless, they decided to repurchase the shares at Rs. 550 to close their position and cap the loss at Rs. 500, besides the commission and interest that may be charged on the trade.

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.

Difference between regular investing and short-selling

While short-selling can be an impactful method to make profits in the financial market, it has certain rules and regulations that make it significantly different from regular investing. One of the most prominent of these is the restriction on short-selling a stock which falls more than 10% in a day compared to the closing price of the last trading day. In addition, the risk of losses in short-selling is infinite, theoretically. This is because the price of a share could possibly increase and grow indefinitely. Thus, despite its impactfulness, short-selling is best leveraged by seasoned traders and investors who have the risk appetite for this method.

Conclusion

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 and start trading.

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Frequently asked questions

What is short selling in the stock market?

Short-selling is a type of trading strategy which involves borrowing a security, selling it on the market, and buying it back later at a lower price to return to the lender profiting from the price difference.

Why is short selling also known as margin trading?

Short selling is also referred to as margin trading since traders typically borrow securities they intend to sell short. You can sell shares of a company even if you don't have them in your Demat account, by using a margin account provided by your broker.

What is the major advantage of short selling?

Short selling has the advantage of leveraged trading, allowing traders to earn profits with borrowed securities. However, this strategy involves higher risk. It enables traders to make a profit in a falling market, unlike traditional strategies that require a rising market to earn profits..

Is short selling legal in India?

Yes, short selling is legal in India, but it is subject to certain regulations and conditions set by the Securities and Exchange Board of India (SEBI) to prevent market manipulation.

Is short selling only for intraday?

Short-selling in India is not limited to intraday trading. However, traders must spot short sales when they place orders. Moreover, naked short-selling is illegal and institutional investors are prohibited from day trading.

Why is it called short selling?

Even though the exact origin is uncertain, it is widely believed that this method is called short-selling because the seller is ‘short’ of the assets they sell, and they need to buy them later to complete the trade. The term ‘short’ also broadly signifies a bet on a price decline.

Why is short-selling illegal?

Short-selling is illegal when it involves selling securities without borrowing or owning them (naked short-selling). This can reduce market supply, potentially lowering prices and harming both investors and issuers.

How does short selling work with an example?

Suppose you believe that ABC stock’s price, trading at Rs. 500 per share, will decrease. To capitalise on this, You borrow 10 shares from a broker and sell them at Rs. 500 each. If the price drops to Rs. 400, you can buy back 10 shares and return them, netting a profit of Rs. 1,000.

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