What is Short Selling?
In the normal course of investing in stocks, the primary objective is to buy low and sell high. You buy a certain stock when you anticipate that its price would go up (based on fundamental and technical analysis). However, there could be a situation where markets are bearish, and you anticipate a fall in the price of a stock. This is where the concept of short selling comes in. In this article, we explain what short selling is and how it works with an example. We will also discuss the pros and cons of short selling and the risk associated with it.
Basics of Short Selling
Short selling is a technique in which an investor/trader borrows securities (like stocks) from a broker and sells it in the market, with the intention of buying them back at a lower price in the future.
Those who expect share prices to fall on a future date can capitalise on their predictions. The method of shorting stocks is very interesting. Firstly, an individual can sell shares that they do not own. Traders would need to borrow these shares from a broker, thus opening a position. Brokers lend the shares to a trader with a promise that they will be delivered back at the time of settlement. The trader would sell these borrowed stocks at the prevailing market rate and wait for prices to fall. This is referred to as shorting the position. When the prices drop, the traders buy back those shares to close the position. Thus, the objective behind short selling is to “sell high and buy low”.
If the share prices fall, traders make a profit based on the difference between the selling price and purchasing price. However, if the trader’s study or prediction fails and the share prices go up, they incur a loss.
How Does Short Selling Work?
Short selling is an activity that allows market participants to profit from the fall in the price of a financial instrument. It involves borrowing an asset from a broker, selling it in the market, and then repurchasing it later at a hopefully lower price to return it to the lender. Here's how the process generally works:
1. Borrowing the Asset
The trader borrows the asset (usually stocks) from a broker or another trader. This borrowed asset is typically done through a margin account, where the investor agrees to certain terms and pays a fee or interest for the borrowed amount.
2. Selling the Asset
After obtaining the borrowed asset, the trader immediately sells it on the market. This is where they take advantage of their belief that the asset's price will decrease.
3. Waiting for Price Drop
The trader waits for the price of the asset to fall. If the price drops as anticipated, the investor can buy back the asset at a lower price.
4. Repurchasing the Asset
Once the price has dropped, the trader uses the proceeds from the initial sale to repurchase the same asset at a lower price.
5. Returning the Borrowed Asset
Finally, the trader returns the borrowed asset to the lender, typically the broker, from whom they originally borrowed it.
6. Profit or Loss
The profit or loss in short selling is the difference between the price at which the asset was sold and the price at which it was repurchased, minus any borrowing fees, interest, or transaction costs.
Short selling can be a risky strategy because there's a potentially unlimited downside. If the price of the asset increases instead of decreasing, the short seller could incur substantial losses. In the worst-case scenario, if the price rises significantly, the losses can be substantial and may even exceed the initial investment.
However, brokers have an automatic liquidation system in place that automatically squares off the position if the required margin is not maintained.
An Example of Short Selling
Suppose a trader speculates or predicts that the stock price of XYZ is bound to decline after a deep fundamental and technical analysis. He feels that the firm has not performed well during a particular quarter. The current share price of XYZ is Rs 100. He borrows 10 stocks of XYZ from a broker and sells them in the market at Rs 100 each. (He receives Rs 1,000 from this sale). Thus, he is getting “short” by 10 stocks. As predicted, the share price of XYZ falls to Rs 75. He then purchases those 10 shares back at the lower rate of Rs 75 per share. Thus, the overall profit from this transaction is Rs 250 (ie, Rs 750 subtracted from the Rs 1,000 he received initially by selling the shares). He then returns those 10 shares to his broker.
Now, what if the trader’s analysis failed, and XYZ’s share price went up to Rs 125? He would then have to spend Rs 1,250 (Rs 125 per share x 10) to buy back the shares that he owes to the brokerage. He gets to keep the Rs 1,000 he earned from selling the shares initially. But, he has lost Rs 250 in this scenario.
How to Short Futures?
One could also short a stock in the futures segment. In the Indian stock markets, if you want to hold a short position for more than a day, the easiest way is to short a future. Futures represent an agreement to buy or sell a specific quantity of a stock at a set price on a specified date in the future. It derives its value from the actual stock. If the underlying value (stock price) is going down, so would the futures.
If you have a bearish view on a stock, you can initiate a short position on its futures and hold on to the position overnight. Similar to depositing a margin while initiating a long position, entering a short position would also require a margin deposit.
What are the Advantages of Short Selling?
- Traders would be able to make significant profits if their predictions become true. It helps you make money in falling (or bearish) markets.
- Short selling can be used to hedge against any downside risks associated with a stock. Traders can use this method to secure their long-term positions in the market and reduce losses.
What are the Disadvantages of Short Selling?
- As mentioned earlier, if the trader’s prediction fails, they are exposed to infinite risk. We would recommend that you stay away from short selling if you are new to trading.
- In short selling, a trader would have to borrow shares from a broker. There is an interest levied on these borrowed stocks, and the trader also has to maintain a margin. If the margin is not maintained, the trader might need to increase funding or liquidate (exit) their position.
- Timing is a very important aspect of short selling. If a trader shorts stocks long before the prices drop, they would have to bear the costs associated with short selling for a longer period. If a trader shorts a stock late, they would not be able to catch the fall that was initially predicted.
- Traders who short stocks could be prone to a short squeeze. This is a situation wherein highly shorted stocks are targeted by certain investors. They would buy these stocks and drive up their prices. Thus, the short sellers would make huge losses when this happens. This is what happened with GameStop, AMC shares in the US. You can read more about it here.
What are the Risks of Short Selling?
A few of the risks of short selling are:
- Potential for Unlimited Losses
- Margin Calls - A margin call is a demand from a broker for an investor/trader to deposit additional funds to cover potential losses in their account.
- Limited Availability of Borrowed Shares
- Regulatory Restrictions and Market Manipulation
- Squeeze Risk
- Timing Risk
Long Position vs Short Position
- A long position means that the investor has bought the shares and is expecting the price to go up.
- A short position means that the investor has short-sold a share and is expecting the prices to fall.
- A long position makes a profit when the price rises while a short position makes a profit when the price falls.
Regulations for Short Selling in India
In order to short stocks, traders need to have a margin account through which they can borrow stocks from a broker. They would need to maintain the margin amount in that account to continue or retain a short position. This margin acts as a security deposit with your broker.
Traders can place a Margin Intraday Square (MIS) order for short selling. This means that selling and buying the stock (short selling) happens during the market hours (9:15 am to 3:30 pm). Brokers will automatically square off your short position towards the end of market hours.
The Securities and Exchange Board of India (SEBI) allows traders to short-sell securities only in intraday trade. The entire process of short selling has to take place within the same day. Due to the Covid-19 pandemic and the negative sentiments surrounding it, global markets crashed in March-April 2020. In order to stabilise markets, SEBI imposed a temporary ban on short selling and increased margin requirements. This ban was lifted in November 2020.