Short Selling Explained – What is Short Selling in Stock Market?

By Trader Pit

July 9, 2021


Short Selling is a way to make money (or lose money) on a stock that you think the market is wrong about. It’s a pretty simple concept, but it’s worth explaining so you understand the basics. Remember, stock can be sold short, or borrowed, or borrowed and then sold. As an investor, you can do one or all of these things. For example, you can borrow 100 shares of stock from a broker and sell them for $100, thereby gaining a $100 profit. At any time during this process, you can buy back the stock for $100 and pay off the loan. This is called an ‘offsetting transaction’.

Short selling is a technique used in the stock market where a trader borrows shares from a seller, intending to sell them back to the seller at a later date, for a profit. The trick is that the trader can sell the shares at a lower price than they paid. The trader usually then buys the shares back with the aim of reselling them at a higher price. The trader hopes the price will drop, making a profit on the sale.

Understand what short selling is and the implications: The terminology of short selling is often used in the capital market. It has also been in the news in the last few days because of the SEBI vs Mukesh Ambani case. The SEBI has fined Reliance Industries Rs 25 crore and Mukesh Ambani Rs 15 crore for altering the settlement price of Reliance Petroleum Ltd. on November 29, 2007, by selling nearly 2.7 million shares short 10 minutes before the market closed. This led to a sharp fall in RPL’s share price and a loss of money for investors in the market.

In this article, we’ll look at what short sales are, how marketers make money with short sales, the pros and cons, and more. Let’s get started.

What is short selling?

short-selling

As the name suggests, short selling involves selling the underlying security. In stock market jargon, a short sale is the sale of shares of a company before they have been purchased, i.e. the sale of the company’s shares without owning them. Private and institutional investors are allowed to sell short.

In other words: Investors or traders sell shares that they do not own (i.e., are not held in a Demat account) and are loaned to them by their broker with the promise that they will be transferred back to the broker at settlement.

Since traders sell first and then buy, the concept of short selling is completely opposite to that of conventional investing (where you buy first and then sell). And as a result, short-sellers make money when they buy back the stock at a lower price. The difference between the selling price and the buying price is the profit of the short-sellers.

Short sales reported

Let’s try to understand the concept of short selling using a case study based scenario. Suppose Mr. X is a regular market trader and takes a bearish (pessimistic) view on the share price of State Bank of India (SBI) and his view is supported by the following factors:

  • A bearish candlestick formation (for example, a bearish Marubuzo) is seen in the market.
  • The previous day’s high remains in place and the market trades below that high.
  • Sales activity in the market increased significantly compared to the previous days.
  • There are other news-related factors that can have a negative impact on SBI’s share price.

For the above reasons, Mr. X believes that the share price of SBI may fall. He expects the market to test support levels in the near term (4% below current price levels). Therefore, to take advantage of the expected downward market sentiment, Mr. X decides to reduce the number of SBI shares. Let’s try to understand this trade:

Share or equityState Bank of India
Type of operationShort selling or shorting
DurationIntraday
Short priceRs. 300
Number of shares500
Profitability target (4%)Rs. 288
Stop LossRs. 305
Total risk of the transaction (500*5)Rs. 2500
Total compensation in trade (500*12)Rs. 6000
Risk/return ratio (2500:6000)5:12

If the price of SBI shares falls in line with Mr. X’s view, he makes a profit of Rs. 6,000 million on his transaction. On the other hand, if the market goes against his opinion, he will lose Rs 2500 crore on his transaction.

Why do traders sell short in the market?

Here are some of the main reasons why traders sell stocks in the short-term market:

Speculate: This is one of the main reasons for taking a short position in the market. If anyone thinks that market strength is about to run out and that we could experience a correction or market weakness, they will go short.

For backup: Hedging as a strategy is very present in the capital market. If someone is positive about the market in the long term, but expects a small market correction along the way, they may opt for a short position. In this case short sellers take advantage of short-term market weakness by taking a short position in the market.

To improve the input: This is one of the interesting justifications for short selling used by experienced traders. Suppose Mr A wants to buy 1,000 shares of ICICI Bank at a price of Rs. 250. The current share price of ICICI Bank is Rs. 270. He eventually bought shares in ICICI Bank at Rs 270 each. Now to improve the entry point of ICICI Bank stock, Mr A sells ICICI Bank stock short as soon as he sees weakness in the market, makes a small profit and improves the entry point of his original purchase of ICIC Bank stock.

READ ALSO: How to do intraday trading for beginners in India?

Rules for short selling of shares

Short selling in the cash market has its own rules and regulations. This must be done strictly on an intraday basis, i.e. the position cannot be rolled over to the next day. So if we sell before we buy in the cash market, the position must be bought before the end of the day.

A short position cannot be transferred to the next day. However, rollovers are allowed in the F&O market and to facilitate this, exchanges already hold margin in a deposit or trading account to offset mark-to-market (M2M) losses.

Benefits of Short Selling

Although short selling is controversial, it is a very important phenomenon for maintaining the balance in the capital market. Here are some of the benefits of short selling:

  • Short selling is a way of correcting irrational overvaluations of shares.
  • It provides liquidity on the capital market.
  • Going short prevents a sudden rise in the price of stocks that are fundamentally weak.

Disadvantages of Short Selling

Here are some of the main disadvantages of short selling in the stock market

  • Short sellers may be exposed to greater risks than ordinary buyers and sellers.
  • Manipulators often use short selling as a method of pushing down the price of certain stocks and thus directly influencing market sentiment.
  • Sometimes it can also be used to take advantage of a counterparty position taken in the F&O market.

Final thoughts

In this article, we have discussed what short selling is and its advantages and disadvantages. A short sale simply means selling shares in a company that an individual does not own. In this case, a person is exposed to a higher risk in the market, but has the opportunity to make high profits. In the recent COVID-19 pandemic period, traders and investors were able to make significant profits due to their skill and understanding of the concept of short selling.

That’s it for today’s market knowledge. We hope this was helpful to you. We’ll be back tomorrow with more interesting news and market analysis. Until then, good luck and have fun investing!

Frequently Asked Questions

What is shorting a stock for dummies?

Shorting a stock is when you borrow a stock from a broker and sell it on the market. You then buy the stock back and return it to the broker, hoping to sell it back to the market at a higher price.

What are short positions or short selling in the stock market?

Short selling is the practice of selling shares of a company that you don’t own in anticipation of a price decline.

How does short selling shares work?

A short seller borrows shares of a company from a broker and sells them. The short seller then uses the proceeds to buy shares of a different company. If the price of the shares of the company that the short seller borrowed from falls, the short seller can buy back the shares at a lower price and return them to the broker. If the price of the shares of the company that the short seller borrowed from rises, the short seller has to buy back the shares at a higher price, which the short seller will have to pay to the broker.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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