Short Selling

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In a normal scenario, the traders buy or sell the securities that they already own. However, in some cases, a trader may borrow some securities like stocks and sell the borrowed securities. This is called Short Selling.

Short Selling is the practice wherein the investor sells the shares that he does not currently own.

The stocks are borrowed from a broker and then sold, in the hope of the prices of the shares going down, so that when the prices go down the investor can buy them at lower prices and return them to the lender.

In this process, the investor is able to make profits due to the difference in the low buying price and the high selling price.

Short Selling Meaning

There are two main reasons why an investor would be involved in the short-selling of shares.

  • Speculation: The investor may be speculating the prices of the shares to go down due to an impending earnings announcement or other factors. In this case, the investor borrows the shares, sells them at a higher price and then when the price goes down he buys them back at the lower price and returns them to the lender and makes profits due to the difference in price.
  • Hedging Risk: Another reason for short selling can be that an investor already holds a long position in the same or related security, and in order to protect himself from the downside risks he short sells the same security to hedge the risks.

Short Selling Example

Let’s understand this concept with the help of an example:

  • The shares of Tata Steel are trading at ₹630 on a particular day and the trader speculates that the prices are soon going to go down due to an impending earnings announcement by the management.
  • The trader borrows 100 shares of Tata Steel from a broker and short sells them in the market, taking ₹63,000.
  • After the results are announced, the price actually falls down to ₹570 per share and now the trader buys 100 shares of Tata Steel by paying ₹57,000.
  • The trader then returns these 100 shares to the lender.
  • In this mechanism, the trader paid ₹57000 and received ₹63000, thereby making a profit of ₹6000, even when he did not own any shares in the company initially.
  • However, if the market went against speculation of the investor and the share price increases to ₹650, the trader will have to buy the shares for ₹65000 to return them to the lender and will incur a loss of ₹2000.

Short Selling Rules & Regulations

As we have understood from the above example that the short-selling process is based on speculation, and instead of profits it may result in infinite losses.

At the same time, when a number of investors decide to short sell the shares of a particular company, it has a huge negative impact on the company’s share price and on the whole market in general.

The company and the market get destabilised.

Due to these reasons, short selling is highly regulated and it is illegal to short sell the shares.

In India, in particular, naked short selling is banned as it involves no intent on part of the investor to provide delivery of the shares he sold. The investor must show proofs of borrowing and must honour his obligation of delivering the securities at the time of settlement.

The investors must also disclose up front that the transaction is a short sale at the time of placing an order.

Short Selling Penalty

Let’s understand this concept with the help of an example.

So, there is a trader named Rajesh. He placed a short-selling trade for 100 shares of ICICI at a price of INR 750. He expects the price to drop and is looking to make a profit out of this trade.

However, the stock sees a jump due to a quick announcement of its new acquisition of a financial start-up.

The stock touches INR 775, thus, eliminating all potential chances of Rajesh making money from this trade.

Furthermore, the trading account of Rajesh must have an amount in the range of INR 77,500 for the broker to square-off his position. However, there is a shortage of funds in Rajesh’s account.

Now, what happens?

In such a case, Rajesh is liable to buy the stocks he chose to short anticipating a profit. He has T+2 days to arrange the funds before the delivery of stocks actually happens.

In the meantime, the exchange does not directly deal with individual traders.

It interacts only with the depository participant or DP, which is basically your stockbroker. Thus, SEBI will deduct the money from the broker’s account and transfer the shares to its account.

Rajesh is supposed to pay back to the broker along with requisite interest applicable.

There is another case possible.

Let’s take another example.

Here we talk about Sanjay, another intraday trader. He is on the other side and promised to provide delivery of 100 shares to the buyer.

He also failed to deliver.

This situation is termed as “Short Delivery”.

So, what happens from here?

Well, in such cases, the broker takes part is something called “Auction Market”. This auction happens on T+2 trading day for 45 minutes between 2 pm and 2.45 pm.

During this event, the stock price decided between the following two options:

  • Highest stock price on the exchange from the trading day till the day of this auction
  • 20% on top of the current price during the auction day.

One of the above is picked up, whichever is higher!

So, when we talk about short selling penalty, these are the different charges that are levied on the trader if he/she fails to deliver (money or shares) while shorting the stocks.

Short Selling Options

This one is relatively riskier strategy.

The simpler reason for that is, it comes with unlimited risk to your principal trading amount and offers a limited profit on your trade.

If you are looking to use short selling in the options segment, you are supposed to perform a detailed analysis of the potential movement and direction of the stock or index.

This is because, if there is a trend reversal, it will directly impact the amount of loss you are going to make in the trade. If this reversal continues, it is going to badly impact the size of loss you are going to make in this trade.

Short Selling Futures

When we talk about short selling in the futures segment, the cap of the potential profit from your trades goes out of the window. In other words, unlike short selling options, this segment allows you to have unlimited profit potential.

At the same time, there is no limit to the risk to your trade value either.

Thus, the ‘high risk-high return’ concept works perfectly fine in this context.

The profit in this form of trade starts happening as soon as the selling price of the futures is higher than the market price of the futures.

If the market price of the futures keeps on decreasing, the profit sees a corresponding increase.

Short Selling in Delivery

Well, you can’t do this.

That is, short selling in delivery trades is not allowed.

You can do short selling in Intraday trades only (as explained above) and you MUST square off your position before the trading session ends, else your stockbroker will do it for you.

You cannot carry forward your position while short selling your stocks.

Short Selling Currency

Yes, you can certainly short sell in your currency trades.

There is one difference in this segment though, as compared to what we normally do in the equity segment.

Here, you are dealing with a pair of currencies. Thus, in a sense, it implies that if you are going short against a particular currency, you inherently are going long on the other currency in that particular pair.

Let’s take an example.

For instance, you look to go short on INR/USD pair assuming that the Indian Rupee is gonna go (further!) down against its US counterpart.

This will imply that it will require more INR units to buy a single unit of a USD.

Now, since two currencies are involved in this transaction, it makes complete sense that you follow a specific process before deciding to go ahead with a shorting of a currency pair.

Here is what we think:

  • Perform a detailed research of the currency pair you wish to go short on.
  • You must ideally be performing both fundamental as well as technical research on this currency pair you have, sort of, finalized.
  • Figure out a strategy that you may want to apply in this trade of yours, some of those have been listed above.
  • Keep a close eye on your position!

This may feel a bit exhausting initially but as long as you keep on following these steps, it will invariably become your second nature to follow this process before placing the trade.

Short Selling Time Limit

When it comes to the time limit, it really depends on the trading segment.

For instance, in the case of the equity segment, you need to exit your position within the same trading session. Like mentioned above, you cannot carry forward your position by any means.

As far as derivative trades are concerned, you have the time limit till the dates of the contract expiry.

Having said that, you can always push forward your expiry by closing the existing one and opening up an equivalent position for the next expiry date.

Whether it is recommended or not, that is a different story.

Short Selling Risk

If you are looking to make more money through short selling, well, the risk level is going to be relatively high too.

Some of the risks of this form of trading include:

  • You are betting against the general market momentum. Thus, the research you perform in order to figure out the stocks for shorting has to be thorough in nature.
  • If the market goes against your expectations, your loss potential is unlimited (at least theoretically). Furthermore, if you do not have that kind of money in your trading account, you are set to pay a lot more on top of what you are actually supposed to pay.
  • Generally, these are short-term trades and require an exhaustive amount of research and thus, takes a lot of toll mentally.
  • Most of the times, the potential gain at stake is fairly limited and there are other forms of trading you can employ that come at relatively much lesser risk.

Short Selling Strategies

If you are not sure which path to follow while performing short selling, you are not going to land at the “Profit Airport”.

Thus, remember to follow a few proven short selling strategies and STICK TO THEM!

Here are those listed for your reference:

  • Ideally, you must never be short selling in a bullish market. The opportunities to go short are generally more visible in the bear market.
  • The blue-chip stocks get affected at the climax. That implies, that during the initial phase of market correction, the bigger stocks will continue to rise before they start getting impacted by the bears. Keep an eye on those stocks!
  • Remember, the short-selling risks are as real as they can get. Never discount that point and stay aware of all those risks while entering in a position. Ignore is NOT bliss here!
  • Using a stop-loss and a target price in these trades is definitely sensible!

There could be other strategies you could employ as well based on your trading experience.

Short Selling Advantages

Here are some quick advantages of short selling in your share market trading:

  • Provides liquidity to the market.
  • Helps in price correction of overvalued stocks.
  • Traders can make money in bearish markets too.
  • Positions can be taken at the margin.
  • Securities can be sold at a better price thus leading to profits.

Short Selling Disadvantages

At the same time, you must know the specific concerns related to the concept of short selling:

  • Short selling poses infinite risks to the investor. If the price of the security goes up, the trader bears immense losses.
  • Increases the price volatility of shares.
  • Affects a company’s share price.
  • Causes destabilisation in the entire market.
  • Can be used for manipulative trading techniques and fraud.

Therefore, it is to be noticed that short selling is a legal activity if done with good intent.

It allows the investor to hedge his risks and to make profits based on his speculation. However, if short selling is done with unethical intent, it can cause harm to the entire market and all the parties.

It may be used by ruthless elements to crash down the prices of a company, but if used efficiently short selling is a great tool for profits and portfolio risk management.

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More on Share Market Education:

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