The objective of short selling is to profit from a drop in the price of an asset. In contrast to conventional investing, which involves purchasing an item and reselling it at a profit, short sellers begin by selling an asset, with the goal of repurchasing it at a lower price.
Short selling is a complicated trading technique that inverts the usual concept of investing. The majority of stock market investing is known as “going long,” or purchasing a stock with the intention of selling it later at a higher price. When traders “short” a stock, they are betting that the price of the stock will drop. To short a stock, a trader must first borrow shares from a broker and then promptly sell that position to other buyers on the market. To complete the transaction, the short seller must repurchase the shares, ideally at a lower price, in order to refund the loaned amount to the broker. If the stock’s price declined as anticipated, the trader would realize a profit equal to the price difference minus fees and interest.
Selling short, as this strategy is also known, is a means for traders to bet on dropping prices or to hedge their position. Although it may sound simple, short selling requires extensive expertise.
If a stock’s price rises instead of falling, the short seller will lose money, not to mention the expenses associated with borrowing shares as part of this trading technique. However, short selling carries a high risk-to-reward ratio, and traders can either make a profit or experience enormous losses via short selling. This article will discuss short selling in the stock market and various important factors to help readers gain a deeper understanding of short selling.
What Is The Purpose Of Short Selling?
In the stock market, short selling is a strategy employed to make a quick sale and gain a reasonable profit in a short period of time. While short-sellers monitor the price environment and profit from falling stock prices, long term investors purchase stocks in the hopes that they will rise in the future.
Investors may engage in the short sale of shares for two main reasons:
- Speculation – The investor may speculate that the stock price of a specific company will decline as a result of a forthcoming earnings report or a number of other important variables. In this scenario, the investor buys the shares, sells them at a higher price, then buys them again at a lower price, returns them to the lender, and earns profits on the price difference.
- Risk hedging – An investor’s long position in a security is another main justification for short selling. He shorts the same security to reduce his exposure to the downside risk.
How Does Short Selling Work?
You will first need a margin account. Borrowing shares from the brokerage is essentially a margin loan, for which you will be charged interest. The process for opening a margin account differs with every brokerage, but you will likely need approval.
You may maintain the short position (i.e., hold on to the borrowed shares) for 24 hours till the market closes for the day. Remember that you’ll be paying interest on those borrowed shares for as long as you hold them and that you’ll also be required to meet margin requirements throughout the term.
If the price of the stock declines, you will close the short position by purchasing the number of borrowed shares at the reduced price, then returning them to the brokerage. To generate a profit, you must calculate the amount of interest, commission, and fees you will incur.
How To Short A Stock?
In a short sale, the seller does not own the stock they are selling. First, short sellers borrow shares of stock from a broker. The borrower then sells the shares at the current market price and receives the proceeds in their account. Later, the short seller must determine whether or not to close out the short sale by repurchasing the exact number of shares sold in order to return the borrowed shares to the lender. The objective of short sellers is to purchase shares at a cheaper price and profit from the difference.
If the stock price rises and the short seller repurchases the shares at a higher price, they will incur a loss. When the price of the stock rises, short sellers may wait it out in the expectation that it will fall; however, since they must ultimately return to the broker, they risk losing more money. When the share price rises, the broker may issue a margin call, compelling the short seller to deposit additional funds or repurchase the stock at the current higher price.
An illustrative example to simplify Short Selling:
Shorting is hard to understand because we don’t usually do it in our everyday transactions. For example, let’s say you buy an apartment for Rs. X today and sell it for Rs. X+Y two years later. The transaction made a profit of Rs. Y, which is the amount of value added on top of Rs. X. This transaction is easy and makes a lot of sense. Most of the things we do every day require us to buy something first and then sell it (maybe for a profit or a loss). These deals are easy to understand, and we’re used to them. In a short sale, or just “shorting,” on the other hand, the transactions go in the opposite direction: we sell first and buy later.
So what would make a trader sell something first and then buy it later? Well, it’s pretty easy. When we think that the price of an asset, like a stock, is likely to go up, we buy the stock first and then sell it later. But if we think the stock’s price will go down, we usually sell it first and buy it later.
Confused? Well, let me try to give you a simple example to help you get the idea for now. Imagine that you and your friend are watching an India vs. Australia cricket match that is very exciting. You’re both in the mood for a little bit. You bet that India will win the match and your friend bets that India will lose the match. This means, of course, that you make money if India wins. In the same way, if India lost the match, your friend would make money. Now, think of India (in this case, the Indian cricket team) as a stock that is traded on the stock market. When you do this, your bet is the same as saying that you will make money if the stock goes up (India wins the match), and your friend will make money if the stock goes down (India loses the match). You are “long” on India and your friend is “short” on India, which is a market term.
still, bewildered? Possibly not, but I would assume you have a few unsolved questions in your mind. If you are new to shorting, just remember this one point: if you believe the price of a stock will decrease, you can make money by shorting the stock. To short stocks or futures, you must first sell and then buy.
Scenario: 1
Hypothetically, if the stock has moved as anticipated. The share price of stock A decreased from Rs.1890/- to Rs.1850/-.Since the objective has been reached, the trader should close the position. In a short position, it is customary for the trader to –
First, sell at Rs.1890/- and then purchase at Rs.1850/-.
The trader would have earned a profit equivalent to the difference between the selling and buying price, or Rs. 40/- (1890 – 1850).
From a different perspective (i.e., the conventional purchase first and sell later perspective), this is equivalent to purchasing at Rs. 1850 and selling at Rs. 1890. The trader has simply reversed the transaction order by selling first and buying later.
Scenario: 2
In this instance, the stock (A) price has surpassed the short price of Rs.1890/-. Remember that when you short, the stock’s price must decrease for you to profit. If the stock price instead increases, a loss will occur. In this instance, the stock price has increased, hence there would be a loss—
The dealer sold short at Rs. 1890. Contrary to the trader’s expectations, the stock rose following shorting.The stock reaches Rs. 1,900, triggering the stop-loss. To avoid incurring additional losses, the trader must finish the position by repurchasing the shares.
Throughout the entire transaction, the dealer would have lost Rs. 10 (1900 -1890). This transaction is equivalent to purchasing at Rs.1890/- and selling at Rs.1990/- if viewed from the traditional buy-first-sell-later perspective, and if the order were reversed, it would be sell-first-buy-later.
Hopefully, the above two examples have demonstrated that when you short, you profit when the stock price falls and lose when it rises.
Benefits Of Short Selling
As a business strategy, financial market intermediaries (e.g., stock brokers) frequently employ short-selling. It promotes market liquidity and efficiency and helps to manage prices, especially for shares that are overvalued. Short-selling enables investors to earn a profit even when markets are falling and protects their portfolios by hedging against a market correction on the shorted stock and other equities in the portfolio. Less money is involved in short selling, and profit can be achieved without even owning the stock. Therefore, it empowers investors to use leverage to take advantage of additional investment and profit opportunities.
Risk Of Shorting
In the case of short selling, the risk is potentially limitless. Those who are long on a stock (those who have purchased the stock) risk the full amount of their investment. Typically, the risk of short-sellers is unlimited as the theoretical upside potential of share prices is infinite. Thus, a short seller’s loss might be severe if the stock price rises significantly before he is able to cover his short position by purchasing the necessary number of shares.
*Again, short-selling carries delivery risk, which occurs when the short-seller is unable to restore the shares within the same day (this occurs when stock prices reach the upper circuit due to significant demand) because he is unable to provide delivery of shares at the time of settlement. In this circumstance, the investor’s broker would purchase the share through the auction market on the investor’s behalf (at a much higher price, in most cases). In addition, investors are compelled to pay a high default penalty to the clearing member.
Final Thoughts
Overall, short-selling contributes to the operation of the financial markets in numerous ways. It enhances market efficiency and enables investors to employ the approach for hedging, speculating, etc. To employ short selling efficiently, investors must have a thorough understanding of market dynamics such as direction, volume, liquidity, and volatility. To better comprehend this, having knowledge of technical analysis can be a plus. To minimize undue exposure to a high level of risk, retail investors with insufficient knowledge of short selling should avoid shorting.
FAQs
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Does short selling involve borrowing stock?
As the short seller “borrows” the shares from the broker and sells them in the market, short-selling stocks involve borrowing. When the seller repays the borrowed shares by repurchasing them from the market, the cycle is finished.
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What happens if you short a stock and it goes to zero?*
This is the best conceivable scenario for a short seller if the stock goes to zero or the stock becomes worthless. Then, the short seller will get 100% of the proceeds.
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How long can you hold a short position on the spot market?
One restriction applies to shorting in the spot market: it must be done exclusively on an intraday basis. The short transaction can be started at any moment during the day, but you must buy back the shares (square off) before the market closes.
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