Understanding Short Selling in the Stock Market

Investing in the stock market necessitates research and study of various financial securities. Buying and selling are vital parts of the trade where a trader is exposed to risks and returns. In this article, we will study what short selling in the stock market is.

Short selling is a kind of intraday or derivative strategy for trading. With short selling, investors can borrow shares from brokers and sell them as soon as possible. After shorting one’s position, one needs to pay back the amount and return the price to the broker. The return price is purchased at the lower price or higher price depending upon the investor keeping the difference in price.

Let’s delve into the basics of short selling, its process, and how it works. 

Meaning of Short Selling

Short selling stocks is a trading strategy where traders short sell on the future decline value of a stock. In short selling, an investor borrows stock shares that they think will drop in price, sells them at market price, and then buys back the shares at a lower price. These borrowed shares complete the short sale. The investor returns the shares to the original lender and gains from the difference between the buy and sell prices. This difference in price is the amount gained by the trader.

Short selling is a short term strategy that can be highly risky depending on the difference between the selling and buying prices.

Purpose of Short Selling

Short selling is a very short and simple strategy to follow. However, it requires planning and accurate stock predictions. In general, short selling is used for two reasons: speculation and hedging.

• Speculating: 

Stock market speculators use the short sell by identifying stocks they think are overpriced and can profit off when the price declines. Short selling speculation is a highly risky investment strategy.

• Hedging:

Most traders who short stocks are often called hedgers. They take short positions, avoiding high risk and simply avoiding a long position in their trade. The longer the trade, the bigger the risk for the hedge fund trader. Hedgers want to minimise potential losses or protect gains on the long position. They use different strategies to cut down on their risk, and short selling is one of them.

Consider an investor named Raman, who has been researching the XYZ company for several months and who believes the stock price is going to fall. Suppose he buys 1000 short shares at a stock price of ₹100. He anticipates that the stock price is going to reduce. He wants to take more time and select the short selling using a margin account to make a short selling. This means he must request approval for a margin account by submitting a margin agreement form.

With the margin account, Raman borrows 100 shares of XYZ from the broker, where he can sell the shares at the current price. Suppose that after selling the shares, the share price falls, and the cost per share is ₹90. Then, he purchases 100 shares and sells them at the current price, earning ₹10 per share. The total difference will be ₹10,000/-, which will be his profit from short sell trade.

But in case the stock price rises, he will face losses, and he will need to pay the broker as per the current stock price, and the difference will eventually be his loss in trade. Therefore, there exists a chance of loss in the trade. Short selling is the practice of selling something that one does not own but borrows from a broker.  When one wants to sell short, one borrows shares from one’s broker to get the shares to sell.

To avail of this loan, one has to be approved for a margin trading account. Brokerages such as Share India provide margin trading accounts that can be opened in a few simple steps with minimal paperwork. The term margin refers to a security deposit that one needs to add to one’s broker account as collateral for borrowed shares.

Benefits of Short Selling

The first and foremost benefit of short selling is that no capital is required. Since the broker is paying for the purchase of one’s securities, one can put up a total percentage of a stock that one wants to trade, which will be a smaller part of the whole investment.

Risks Associated with Short Selling

Although shorting stocks comes with the chance of getting better returns, there are quite a few risks one must know about:

• In contrast to a long trade, where one can only lose the money one puts in, a short trade may lead to high losses if the price of the stock rises.
• One must pay an additional cost in the form of upfront margin account money and interest fees that return until one returns borrowed shares. 

Short Selling and Its Process

For a better understanding, let’s see how short selling works.

• In short selling, a trader does not need to buy shares. These are borrowed from a broker.
• Short selling can be done by a retail or institutional investor.
• A seller bets on the fall of the stock price and purchases the shares again if the stock price falls. But if things go the opposite, the trader needs to suffer losses.
• Traders who follow the trade properly and repay on time can avoid interest and penalties in the following instalments.

Conclusion

Short selling is a challenging and experienced way of trading, so if one is a novice trader, it’s better to avoid this type of trade. A person with extensive knowledge and experience in intraday trading and effective risk management can perform such trades.

Frequently Asked Questions (FAQs)