What is Short Selling in Stock Market?

Imagine you are a vegetable vendor in your local mandi. Onion prices are running irrationally high. You don't wanna miss the opportunity. But you've already sold out all your onions that day. So, you make an arrangement… you borrow some onions from your neighbouring vendor and assure him to return a few more onions than what you borrowed after a few days. Then, you sell these onions now at the prevailing high price. And once the price of onions drops, you buy them, then you return the borrowed onions and make profits from the excess sale proceeds. Simple, isn't it?

Well, when this desi jugaad makes its way to the share market, they name it - "Short Selling".

Say you did thorough research of a particular company and realised that the value of its stocks is overvalued. Now, you are anticipating the price of that particular stock to fall. In that case, you will probably look for ways to make money out of it, and that is when short-selling comes into the picture   

Understanding Short Selling

Short Selling is a process wherein the investor borrows stocks through his broker and sells them at a higher price. He later purchases them when the prices come down to return the stocks to the lender and makes the difference in two amounts as his profit.

As specified earlier, the stocks which are dealt in here are neither owned by the investor nor are held in the Demat form. Usually, short Selling is carried out by a trader when they are looking to hedge their positions and protect their portfolio from a probable downfall. Investors also utilise this for making a few bucks on the downfall of a particular stock.

Such a method is handled by investors in big numbers when there is a bearish market. However, the market permits only retail and institutional investors to do short Selling. So how does it work exactly? Let's look at the example below to get a clearer understanding. 

Say you are hoping for a fall in the price of ABC Ltd from Rs. 100 to Rs. 50. Now you borrow 10 shares from your broker at a nominal interest and for a specified period and sell them in the market. Note that you are entitled to return the share on or before the stipulated period. When the prices fall, you repurchase and return them. Through this, you make a profit of Rs. 500 (Rs. 1000 – Rs. 500).

On the other hand, if the prices rise from Rs.100 to Rs.120, then you will be forced to meet losses. You make a loss of about 200 in no time because of a wrong calculation. 

In all these cases, you should maintain a certain margin in your account. If it falls short of the specified margin, then you will be asked to take immediate steps to fulfil it. In the worst scenario, you might also be asked to liquidate your position to fulfil your obligation. 

Margin, however, does not apply to an investor or a fund manager who already has possession of securities and is involved in short Selling for hedging.

Pros of Short Selling

Short Selling is one way to make a good profit in a short period. Adding to that, you can use short Selling as a potential insurance option to protect your portfolio from unforeseen risks and problems. It also helps you reduce your overall portfolio volatility. Short-selling facilitates liquidity in the market and enables better price discovery. To sum up, short sales allows you to potentially obtain a large return without putting much money upfront. You only have to invest in the fee to your broker. If you're right, and the stock price plunges, the rest is yours to profit.

Cons of Short Selling

If you look at the other side, there are a wide range of risks in it as well. There is no limit as to the amount you would involve in the speculation. Hence, the higher the amount, the higher will be the damage sustained if the tides don't turn your way. Here, time is the key factor. Selling before or after the expected date might incur a lot of variations in the estimated returns. Also largely, you might be forced to borrow funds from the broker to facilitate the entire process. In such a case, you will require collateral to get the funds. 

Things to remember when Short Selling 

• Short Selling though legal in our country, can be stopped at any point of time to avoid any sort of unwanted panic in the markets. 
• If you are looking to short against stock that is limited in supply, then the investors will be required to pay an extra fee to acquire the stock. The fee might be fixed on a daily basis. 
• The stock market is filled with uncertainty. And short Selling, a method that involves enormous risk, would be suitable only if you are a professional, holding abundant knowledge about the market. If you are a novice or a person with a low-risk profile, it is better to stay away from such methods. 
• A short squeeze is a situation where things don't happen as expected, and short-sellers start buying back the share in order to fulfil their obligation. This drives the price so high, causing a short squeeze. 

Short Selling - a snapshot

• Short Selling is selling the shares that are not owned by the seller and is not in his Demat account
• These shares are lent by the Broker with a promise that they will be delivered back to the broker.
• Retail and Institutional investors are permitted for short Selling.
• Short Selling is based on speculation.
• The trader has to honour their obligation and return the shares to the owner at the time of settlement.
• If the price of the share falls, the trader can buy back the stock at a lower price and make a profit. However, if the profit of the stock rises, the trader buys it back at a higher price and will have to incur a loss. 

Conclusion

While this method is a potential way through which an investor can make attractive returns, it brings along huge risks as well. Hence, it is advisable to clearly define your objectives and follow them. Opt for short Selling only when it is deemed highly necessary, provided your risk profile is high.

Happy investing!