Short Selling in Stock Market: Meaning, Benefits & Risks Explained

Short selling is a method in which you sell shares or securities that you don’t have in your demat account using a margin account. In such a case you can borrow the shares or securities from your broker by paying a margin fee. You also have to ensure that you return the borrowed shares to your broker at the end of the settlement cycle – which is usually a day in the case of stocks and longer in the case of currencies, futures and options.

The concept of short selling is based on the premise that the price of a particular security will come down and you can profit from the decline in prices. When you normally buy a stock, you hope for the prices to go up so that you can book a profit. However, it is the opposite in the case of short selling, you are hoping to make a profit when prices go down by selling shares that you don’t possess. Sounds strange, but that is what short selling is all about!

What is Short Selling in the Stock Market?

Short selling is a strategy used in the stock market for quick transactions aimed at making profits from declining stock prices. This approach contrasts with long-term investors who purchase stocks with the expectation that their value will increase over time. Short-sellers capitalize on anticipated drops in stock prices.

There are two main motivations for investors to engage in short selling:

1. Speculation – An investor might predict that a company’s stock will decline due to upcoming earnings reports or other significant factors. The strategy involves borrowing shares and selling them at current prices. If the prices drop as expected, the investor buys the shares back at the lower price, returns them to the lender, and profits from the difference.
2. Hedging Risk – Investors might use short selling as a protective measure when they already hold a long position in a related security. By short selling the same or a related security, they can hedge against potential losses in their existing investments.

What Is Short Selling in Trading and How It Works?

Now let’s learn how short selling in stock market works with an easy to understand example.

Example

Harish has heard that ABC Bank is in deep financial trouble and he expects the price of the stock to go down. He calls his broker and tells him that he wants to short 100 shares of ABC Bank. To fulfill this order, Harish’s broker needs to find 100 shares of ABC Bank and lend it to Harish.

Next, his broker checks through his stock inventory and his client’s portfolio. If he still can’t find them, he can ask other brokers to sell it to him. Finally, Harish’s broker finds the shares in one of his client’s portfolios and he (the broker) sells the share in the market for Harish. At the time when he sold 100 shares of ABC Bank, it was trading at ₹150 per share. Therefore, the broker credits ₹15,000 to Harish’s brokerage account.

In the course of the day, Harish’s bet is proven right. As bad news travelled fast about ABC Bank’s financial troubles, it plunged down to ₹120 per share. Now Harish again calls his broker and asks him to cover/square off his position in ABC Bank. The broker uses the money from Harish’s brokerage account to buy 100 shares of ABC Bank from the market at the current price of ₹120 per share, which comes to a total of ₹12,000. Then, the broker returns the 100 stocks of ABC Bank to his other client’s portfolio.

Now, Harish has sold 100 shares of ABC Bank for ₹15,000 and bought it back at ₹12,000, making an easy profit of ₹3,000. Harish will have to pay a small margin amount from his profit to his broker to get the right to borrow the stock from him.

Advantages and Disadvantages of Short Selling

Short selling in trading offers both benefits and drawbacks:

Advantages

– Profit from Market Downturns: Short selling allows investors to profit from declining stock prices, providing an opportunity to make money even when the market is bearish.

– Portfolio Hedging: Short selling can serve as a hedging strategy against potential losses in a long portfolio. By shorting certain stocks, investors can offset losses from declining prices in other holdings.

– Price Discovery: Short selling contributes to price discovery in the market by reflecting pessimistic sentiments and revealing overvalued stocks.

Disadvantages

– Unlimited Losses: Unlike buying stocks, where losses are limited to the initial investment, short selling carries the risk of unlimited losses if the stock price rises significantly.

– Margin Calls: Short sellers may face margin calls if the stock price increases sharply, requiring them to deposit additional funds or close their positions at a loss.

– Market Manipulation: Short-selling activities can potentially manipulate stock prices, leading to market volatility and investor distrust.

While short selling can be a profitable trading strategy, it requires careful risk management and market analysis to mitigate potential downsides.

Risks Associated with Short Selling

Short selling in the stock market presents profitable opportunities for higher returns with minimal upfront investment, typically around 20-25% of the stock’s actual cost. However, it entails significant risks that investors should carefully consider:

1. Unlimited Losses: Unlike buying stocks, where losses are capped at the initial investment amount, short selling carries the risk of unlimited losses. If the stock price rises substantially, short sellers may face significant losses beyond their initial investment.
2. Price Volatility: Short selling exposes investors to price volatility, as stock prices can fluctuate unpredictably during the trading period. Sudden spikes in price can lead to substantial losses for short sellers.
3. Expertise Requirement: Short selling requires in-depth knowledge, extensive research, and market expertise. Investors must dedicate considerable time and effort to understand market dynamics and identify profitable short-selling opportunities.
4. Market Timing: Successfully executing short-selling trades relies heavily on accurate market timing. Mistiming the market or failing to anticipate price movements can result in substantial losses.
5. Limited Availability: Availability of stocks for short selling may be limited, especially during periods of high demand or when stocks are heavily shorted by other investors.
6. Regulatory Risks: Short-selling activities are subject to regulatory scrutiny and may face restrictions or regulatory changes that can impact trading strategies and profitability.
7. Margin Calls: Short selling involves borrowing stocks from a broker, which requires maintaining a margin account. If the value of the shorted stock rises significantly, the broker may issue a margin call, requiring additional funds to cover potential losses or forcing the investor to close the position at a loss.

Wrapping Up!

You have to understand that short sale in share market is not for everyone. You have to invest a lot of time and research to gain expertise in short selling in the stock market. Short selling is also used as a hedging (investment protection) tool in a bearish market. If you are not sure about short selling securities, trading experts at Angel One can assist you with the right steps so you can trade with confidence. Start with an Angel One demat and trading account, today!

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