Navigating the world of short selling: What it is, benefits and risks involved

Short selling is the practice of selling borrowed securities – such as stocks – hoping to make a profit by buying them back at a price lower than the selling price. In other words, when you short sell a stock, you’re looking to profit from a decline – rather than an increase – in price.

Read on to discover the dynamics of short selling, its advantages, disadvantages, and how it differs from conventional investing.

• Table of contents

1. Understanding short selling
2. How short selling works
3. Factsheet of short selling
4. What are short selling metrics?
5. Benefits of short selling
6. Drawbacks of short selling
7. Risks of short selling
8. Example of short selling for a profit
9. Difference between regular investing and short-selling

Understanding short selling

Short selling involves selling a stock that you do not have. You borrow shares from a broker or a fellow investor, sell them at the prevailing market price, and later buy them back and return them to the slender. You hope to buy back the shares at a lower price and profit off the difference between the sale and purchase prices.

How short selling works

To engage in short selling, you typically need to open a margin account with a broker. This account allows you to borrow money or securities from the broker to execute trades. Here’s a step-by-step overview of how short selling works:

1. Identify a stock to short: You select a stock that you believe will decrease in value.
2. Borrow shares: Your broker locates shares to borrow, often from other clients or institutional lenders.
3. Sell the shares: You sell the borrowed shares at the current market price.
4. Monitor the stock: Keep an eye on the stock's performance, waiting for its price to drop.
5. Buy back the shares: Once the price falls, you buy back the shares at the lower price.
6. Close the position: Return the shares to the lender and keep the profit, minus any fees.

Factsheet of short selling

• Margin requirements: Short selling requires maintaining a margin account, which involves paying interest on borrowed shares and meeting minimum balance requirements.
• Dividend payments: You are responsible for paying any dividends declared during the short period to the lender.
• Stock splits: If the stock splits, you'll need to return more shares at a lower price.
• Short squeeze: A situation where many short sellers are forced to buy back shares quickly, driving up the stock price.

What are short selling metrics?

Two key metrics help track short-selling activity:

1. Short interest ratio (SIR)- This measures the number of shares shorted compared to the total shares floating in the market. A high SIR indicates strong bearish sentiment.
2. Short interest to volume ratio- Also known as the days-to-cover ratio, it shows how many days it would take to cover all shorted shares based on average trading volume.

Benefits of short selling

• Profit from declines- Short selling allows you to profit from falling stock prices, providing an alternative to traditional long positions.
• Market efficiency- It helps maintain fair market prices by identifying overvalued stocks and increasing market liquidity.
• Hedging- Short selling can be used to hedge against potential losses in long positions.
• Liquidity- Short selling increases trading activity in the market, thereby adding liquidity.

Drawbacks of short selling

• High risk: The potential for unlimited losses exists if the stock price rises significantly.
• Costs: You incur costs such as interest on borrowed shares, dividends, and commissions.
• Margin call: If the stock price rises, you may face a margin call, requiring additional funds to maintain the position.

Risks of short selling

• Infinite loss potential- There is no cap on how high a stock price can rise, leading to potentially catastrophic losses.
• Short squeeze- A rapid increase in stock price can force you to buy back shares at unfavourable prices.
• Market volatility- Unpredictable market movements can lead to unexpected losses.

Example of short selling for a profit

Imagine you short 100 shares of XYZ stock at Rs. 500 each. If the price falls to Rs. 400, you can buy back the shares and return them to the lender, earning a profit of Rs. 10,000 (Rs. 500 - Rs. 400 per share). However, if the price rises to Rs. 600, you'll incur a loss of Rs. 10,000.

Difference between regular investing and short-selling

Regular investing involves buying stocks with the expectation that their prices will rise. In contrast, short selling involves selling borrowed stocks with the anticipation that their prices will fall. While traditional investing limits your potential loss to the amount invested, short selling exposes you to potentially unlimited losses if the stock price surges.

Conclusion

Short selling is a sophisticated trading strategy that requires careful consideration of risks and rewards. While it offers the potential for high returns and helps maintain market efficiency, it also involves significant risks, including unlimited potential losses. As you explore short selling, remember that it is not for the faint of heart. For those interested in more conservative investment strategies, mutual funds can provide a diversified portfolio with lower risk, though they may not offer the same speculative opportunities as short selling.

Read Also: The world of stock trading: Definition, forms and history
Read Also: A chance to make gains when the market falls: Understanding inverse ETFs

FAQs:

What is short selling in the stock market?

Short selling is the practice of selling stocks you do not own, typically by borrowing them from a broker, with the intention of buying them back later at a lower price to make a profit.

Why is short selling also known as margin trading?

Short selling is often referred to as margin trading because it involves borrowing money or securities from a broker, which requires maintaining a margin account.

What is the major advantage of short selling?

The major advantage of short selling is the ability to profit from declining stock prices, which can be particularly beneficial in bearish markets.

Is short selling legal in India?

Yes, short selling is legal in India and is regulated by the Securities and Exchange Board of India (SEBI).

Is short selling only for intraday?

No, short selling is not limited to intraday trading. You can hold short positions for as long as you wish, provided you meet the margin requirements and the lender does not recall the shares.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.