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!
Short selling in stock market – Simple explanation
Short selling in share market can be explained in 7 simple steps:
1. Open a margin account
2. Find a stock whose prices are likely to come down
3. Borrow the stock from your broker
4. Sell the stock
5. Buy the same stock before the settlement period
6. Return the stock to the broker
7. Keep the difference between the selling price and the buying prices as your profit
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.
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 clients’ 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 (broker) sells the share in the market for Harish. At the time when he sold 100 shares of ABC Bank, it was trading at Rs. 150 per share. Therefore, the broker credits Rs. 15,000 in 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 Rs. 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 Rs. 120 per share, which comes to a total of Rs. 12,000. Then, the broker returns the 100 stocks of ABC Bank back to his other client’s portfolio.
Now, Harish has sold 100 shares of ABC Bank for Rs. 15,000 and bought it back at Rs. 12,000, making an easy profit of Rs. 3,000. Harish will have to pay a small margin amount from his profit to his broker for getting the right to borrow the stock from him.
Risks associated with short selling
Short selling in share market offers opportunities for higher returns by spending just 20-25% of the actual cost of stocks. However, it also comes with high risks of incurring losses. Generally, when you buy a stock for Rs. 10,000, your losses are limited to Rs. 10,000 only. But in short selling, you are never sure how high a stock price can rise during the course of trading.
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!