What Is Short Selling In Stock Market

Investors tend to use a variety of strategies to maximise their gains in the stock market. Short selling is one such approach that is often reserved for more experienced and risk-tolerant traders. So, what is selling short on the stock market? Simply put, it is selling shares that you do not own and hoping that their price will fall. Let us take a look at what short selling is in the share market, understand how this strategy works and discover the specific circumstances that can make it rewarding.

What is Short Selling

Short selling, or "shorting," is an investment technique in which shares are borrowed from a broker and sold at the current market price. The plan is to repurchase these shares at a cheaper price in the future, return them to the broker, and pocket the difference as profit. Unlike long positions, which involve buying cheap and selling high, short selling bets on the stock's price decline. This method is often used in a bearish market, where share values are trending downward.

How Does It Works

The process of short selling begins with borrowing shares from a broker. The trader subsequently sells the borrowed shares at the current market price, resulting in a "short position". The trader expects that the share price will fall, allowing them to buy back the shares at a lower price and return them to the broker. The profit is calculated as the difference between the selling and buying prices, minus any interest or fees levied by the broker for borrowing the shares.

For example, if you feel a stock at ₹ 200 is overpriced and would collapse in price, you may borrow 100 shares and sell them for ₹ 20,000. If the stock price drops to ₹ 150, you may purchase back the 100 shares for ₹ 15,000 and return them to the broker, earning a profit of ₹ 5,000 (₹ 20,000 - ₹ 15,000), minus fees and interest.

What are Short Selling Metrics

To successfully engage in short selling, traders use certain measures to identify stocks that are expected to decline in value. The Days to Cover Ratio and Short Interest Ratio are the two most common metrics used.

• Days to Cover Ratio:

  This metric, also known as the short interest to volume ratio, compares the number of presently shorted shares to the average daily trading activity. A greater ratio suggests that a stock is heavily shorted and may be difficult to cover if the price rises.

• Short Interest Ratio:

  This ratio compares the number of shares sold short to the total number of shares available for trade. A high short interest ratio indicates a bearish outlook on the stock, but it also increases the likelihood of a short squeeze, in which short sellers rush to purchase back shares to cover their positions, thereby driving the stock price upward.

When is Short Selling Profitable?

Short selling can be profitable when a trader accurately forecasts a stock's price decline. For example, if you short sell a stock for ₹ 300 and the price lowers to ₹ 200, you may buy back the stock at the lower price, return it to the broker, and retain the ₹ 100 profit per share.

Consider this example: Ajay predicts that the stock price of XYZ Ltd., which is presently trading at ₹ 500, will fall once the business issues its quarterly report. He borrows 50 shares of XYZ Ltd. and sells them for ₹ 500, earning ₹ 25,000. When the stock price drops to ₹ 400, Ajay buys back the 50 shares for ₹ 20,000, returns them to the broker, and makes a profit of ₹ 5,000 (₹ 25,000 - ₹ 20,000).

When Does Short Selling Result in Loss?

The risks of short selling might result in huge losses if the stock price swings against the trader's expectations. Unlike buying stocks, where the potential loss is limited to the initial investment, short selling exposes the trader to potentially incur limitless losses. If the stock price increases rather than decreases, the trader must repurchase the shares at a higher price, resulting in a loss.

If you short sell a stock for ₹ 100 and it increases to ₹ 150, you'll need to buy back the shares at the higher price, resulting in a ₹ 50 loss per share. If the price continues to climb, your losses may compound.

Benefits of Short Selling

• Profit from Declining Markets:

  Short selling allows traders to profit from a declining market while also protecting against long holdings.

• Liquidity and Price Discovery:

  Short selling increases market activity, which leads to higher liquidity and more accurate price discovery.

• Hedging:

  Short selling allows investors to hedge against future portfolio losses by holding short positions in linked assets.

Drawbacks of Short Selling

• Unlimited Loss Potential:

  If the stock price increases rather than decreases, losses might be endless.

• Margin Requirements:

  Short selling necessitates a margin account, which implies that traders must keep a minimum amount. If the account balance falls below the needed margin, traders may get margin calls, forcing them to deposit additional cash or sell holdings.

• Borrowing Costs and Interest:

  Borrowing shares incur costs, such as interest and possible fees, which can reduce earnings.

• Market Restrictions:

  Regulators may impose limitations or bans on short selling during periods of extreme volatility in order to avoid market manipulation and panic selling.

Understanding the Difference Between Regular Investing and Short-selling

Understanding the differences between regular investing and short selling is crucial for any investor.

• Basic Principles:

  1. Regular Investing: This classic approach is purchasing stocks with the intention of long-term gain. You buy shares at a given price, keep them, and hope to sell them at a better price.
  2. Short Selling: Short selling is borrowing shares and then selling them with the anticipation that the price will fall. You then repurchase the shares at a cheaper price to profit.

• Risk and Reward:

  1. Regular Investing: The risk is restricted by the amount invested. For instance, investing ₹ 10,000 results in a maximum loss of ₹ 10,000. The potential profit is theoretically endless.
  2. Short Selling: Short selling involves potentially limitless risk. If stock prices rise, you may face huge losses since you must repurchase at higher prices.

• Market Conditions and Time Horizon:

  1. Regular Investing: Ideal for positive markets with a long-term outlook, benefiting from dividends and market growth.
  2. Short Selling: Common in bearish markets with a short-term emphasis. Borrowing fees and keeping a margin account are among the costs.

• Regulations and Purpose:

  1. Regular Investing: Less restrictive and ideal for long-term wealth accumulation.
  2. Short Selling: Subject to stricter laws and is frequently employed for speculation or loss mitigation.

Conclusion

Short selling is a complex stock market strategy that, when implemented successfully, may result in huge gains. However, it also carries substantial risks including the possibility of unlimited losses. Understanding the mechanics, metrics, and timing of short sales is critical for any investor thinking about this strategy. While it provides benefits such as hedging and significant earnings, the drawbacks, such as borrowing costs and being susceptible to short squeezes, must be carefully considered. As with any investment plan, thorough research and a clear grasp of the risks and benefits are crucial for success.