Short selling or shorting is when a capital market trader or investor sells a security at a certain price without actually owning it and purchases it later at a lower price. As soon as the stock price falls, the investor buys back the shares to fetch profits. However, short selling involves a high risk to reward ratio, as traders may either earn profits or incur huge losses through such trades.
Here, we will explore the concept of short selling in detail and other factors surrounding it.
How does short selling work?
In short selling, traders sell stocks before owning them. So, how can one sell something without owning it? Let’s understand this with an example:
Normal trading – Long position: buy first and sell later
In a normal trading scenario, an investor enters into long positions if he/she believes that the stock price may rise.
Suppose Mr. A buys 100 shares of Infosys at Rs. 500 per share. He expects the share price to rise and, as per his expectations; it goes up to Rs. 550. He then sells the 100 shares and books a profit of Rs. 5,000.
Short selling: sell first and buy later
In this, an investor makes the exact opposite move of the previous example. He will look for an overpriced stock or one which is not doing well, so its price is likely to fall.
Using the above example, suppose Mr. A thinks that the stock price of Infosys may drop to Rs. 450. He short sells 100 shares at Rs. 500 each. If the price drops to Rs. 450, he can buy back the 100 shares and book the difference of Rs. 5,000 as profits, calculated as:
Selling price = 100 X 500 = 50,000
Buying price = 100 X 450 = 45,000
Difference or profits = 5,000
Thus, the investor sold the shares first without owning them. As the price drops, he buys back the same shares at a lower price, resulting in short selling.
Short selling is done by borrowing the stock from the broker and this can be done by investors who have approval for margin trading. The margin in such trading acts as a security held with the broker. An investor must have sufficient cash in the stock trading account as margin requirement, which can vary across brokers.
Why do stock market investors use short selling?
Short selling is mostly used by stock market traders to make quick profits within a short time. While long-term investors invest in stocks for profits through future capital appreciation, short-sellers consider the price situation and aim for profit through falling prices.
Here are the two common reasons why investors do short-selling of shares:
- Speculation – If an investor believes that a company’s stock price may fall because of a potentially poor financial performance or other factors, he/she may sell them at a higher price and as the prices fall, he/she can repurchase to book profits through the price difference.
- Hedge against risk – Short selling is also done by investors to protect against downside risks while holding any long positions in a security.
What are the benefits of short selling?
The main advantage of short selling is leverage. As short sellers can carry out transactions through margin trading, they only need to block a certain percentage of the trade’s net value and can thereby make more money with a relatively smaller investment.
Short-selling can help multiply profit opportunities since a trader can earn positive returns if the stock price rises and also if it decreases.
This trading strategy can also offer additional risk protection for an investment portfolio, as short positions can be used to hedge long positions within a portfolio.
What are the drawbacks of short selling?
Historically, trends suggest that stock prices move towards higher values. However, short selling works on a contrary approach to the overall price trends in a stock market.
With regard to the trading costs, apart from the interest charges, traders may also have to shell out a “hard to borrow” fee in case the stock being sought is hard for the broker to acquire easily for further lending it to investors.
What are the risks involved in short selling?
Here are some of the risks surrounding short selling that every investor should know:
- Market regulations
While market regulators permit short selling, there can be specific restrictions on certain stocks to safeguard investors and to avoid panic decisions that can lead to stock price rises.
- Timing error
Making profits through short-selling depends on the stock buy and sell timings chosen by the investor. While stock prices may not fall soon, an investor waiting to book profits from the stock is still liable to pay towards the margin and interest.
Short selling involves margin trading. Here, a trader borrows funds from a broker by keeping an asset called collateral. They also need to compulsorily maintain a certain percentage as a margin in the account. In case the margin is short of the requirement, the trader is asked to provide for the shortfall.
- Stock selection
Most companies experience turbulence in the business. With appropriate course of action, the company can recover from any fall and bring back its stock value to acceptable levels. While making stock selection, if a trader picks the wrong company, he may lose by taking a short position, while those in a long position may end up gaining.
In the long run, stock prices tend to fluctuate and experience both rise and fall. Short selling is based on the idea of stock prices falling down, which is against the usual trading pattern. Since it is about margin trading, investors must be careful about their decisions and expertise in short selling.
No, short selling does not involve delivery of shares since these are not present in the seller’s Demat account and are borrowed by the seller by a broker.
Yes, short selling is based on the agreement that the seller will return the shares to the broker once these are bought back from the market after a drop in the prices.
Yes, both retail and institutional investors are allowed to do short selling.
Short selling is done with an idea that the price of the stock will drop, which will allow the investor to book profits since he/she would have sold it at a higher price. In case the stock price rises at the time of buying back, the investor incurs losses.
Short selling can fetch profits in a bearish market condition when the general sentiment is that the stock prices will drop.