Let me start this article from where I left off in my previous article in this module. In the last article, I discussed futures trading. We have seen that stock futures can be bought. But an obvious question arises where the seller is selling. Futures are not stocks and the seller does not have the possession of the stock. So wherefrom he is selling? So in this article, I will discuss what is short selling. I will describe the shorting of stocks and futures with the short-selling example.
What is Short Selling?
So the buyer of stock or future always can say that I want to buy this stock or future as I know the price of the same may go up. But wherefrom the seller is selling when he doesn’t have any possession? But a seller can also do so in the future. Only in future trading, someone can sell a stock future or an index contract even if he or she doesn’t have possession. This is what is short selling or in simple terms “shorting”. Many times you have read in the newspaper or heard on the TV that shorting is going on or shorts are created in the market or short covering is going on, so you now have the answer.
Features of Short Selling
- So in simple terms what is short selling can be answered as someone is selling you a stock future at some price that he does not possess.
- So it is a risky way to profit from the declining stock prices.
- You can only do this in the stock futures market, nowhere else.
- Shorting is also possible in the intraday cash market as well.
- A very important point to remember is that in the cash market, shorting is possible only in day trading but not in delivery.
- When we buy a stock or future we expect the price to go up. On the other hand, when we short a stock we expect the price to go down. Shorting of stock or future is the inverse of buying it.
Example of Short Selling
Let’s discuss a short-selling example. Suppose, Ramu owns a property worth Rs. 10 Lacs. Ravi wants to buy the property but he did not know the owner. So he approached a broker named Roshan, who does not own the property, still, he assures Ravi that he can sell the property. Roshan knew the property price is Rs. 10 Lacs. So he asks Ravi to pay Rs. 15 Lacs. Ravi bargains that he can pay only 13 Lacs. Roshan agrees to the deal and he makes a contract that he will sell the property at Rs. 13 Lacs after a pre-fixed time. Now Roshan can Pay Rs. 10 Lacs to the property owner Ramu and hand over the property to Ravi who is paying him Rs. 13 Lacs. So this extra 3 Lacs is profit of Ravi. And this is what is short selling.
Real-Life Example from the Stock Market
Now let’s discuss a short-selling example of the stock market. Ravi has heard that Bajaj Auto is in financial trouble and he expects the stock price to go down intraday. In order to profit from his analysis, Ravi will now short Bajaj Auto. So Ravi opens up his broker’s terminal, says Zerodha Kite, and opens up a short sell order for 100 quantities in MIS.
Now the order management system of the broker and the stock exchange will automatically find the stock in-stock inventory as well as in the client’s portfolios. Say Ravi’s broker Zerodha, finds Bajaj Auto stock in one of their client’s portfolios and borrows it. The broker will now sell the share on the market for Ravi. Say the sell order gets executed at the price of Rs. 3240. The stock will temporarily be credited to Ravi’s trading account.
Ravi was right, after 2 hours Bajaj Auto’s share price dropped to Rs. 3100. Because the stock price has dropped, Ravi can now make a profit by buying back the stock or covering the short. So he now opens up a buy order in MIS
Now, think if the order gets executed at Rs. 3100. The broker will use the money from Ravi’s trading account to buy 100 shares of Bajaj Auto. So Ravi sells the stock at Rs. 3240 and buys it back at Rs. 3100. So he makes a profit of Rs. 3240 – Rs. 3100 = Rs. 140. His net profit is Rs. 140 x 100 shares = Rs. 14000. Ravi has to pay the broker the margin money for the right to borrow the stock.
Risks Associated with Short Selling
So we have discussed what is short selling and we have also seen a short-selling example. It should be practiced only by advanced traders as it is extremely risky. Unlike buying a stock or going long, where your losses are limited, your losses can be unlimited when you are short. Why risk is unlimited can be explained by the price versus profit graph. Suppose you bought stock worth Rs. 100, the maximum loss that can be is Rs. 100. If the stock price goes up, your profits will continue to go up as well. Here actually there is no limit on how high the price can go.
Now consider you have shorted the same stock at Rs. 100. In this case, you profit only when the profit decreases. Your maximum profit can be Rs. 100, i.e. the price of the stock. But if the price goes up your loss will also go up. There is no limit on how far the price of the stock can go up. So, your losses can be theoretically unlimited.
Difference between Short Selling in the Cash Market and the Futures Market
As we already discussed that one can short in the cash market as well as the derivative market also. In the intraday cash market, the cover of the short is to be done on the same day as we saw in our short-selling example. But in the futures market, the short can be covered on or any time before the expiry date. Till the time, the short is covered in the futures market, the margins will remain blocked and MTM settlements will be done regularly in the trading account.
Short selling involves selling a security that the investor does not own, and then buying back after prices go down later to make a profit. For example, if an investor believes that the share price of CL Educate will go down in the future, they can sell it first and buy it when it goes down at a lower price.
When an investor wants to engage in short selling they borrow securities from another party usually through their broker and sell them on the open market. When the stock has gone lower than initially sold, they buy new shares at a lower price and return these borrowed shares to complete the transaction thus making a profit out of the net difference between the costs of original sale & purchase.
Yes, Short Sellings are legal as per Indian Markets Regulations. There are certain regulations for settlement cycles for intraday trades or delivery-based transactions which must be complied with. It’s always advisable that you consult your stockbroker before initiating any such transaction.
In simple words, short-selling refers to borrowing stocks from other investors/market makers by paying interest cost, then lowering its market value and now closing position by repaying the higher value of stocks borrowed originally plus returns earned during this process minus interest cost paid earlier – thus making profits out the money invested during the shorter duration.
Not only buying, but traders can also make money by short-selling the stock too. We discussed shorting stocks and futures and focussed on its risky side too. However, traders can practice shorting in the market and become proficient in shorting the same way as in buying.