Short Selling

Short selling refers to taking the selling position on security (stocks, commodities, currency, etc.) and buying them at a later date to square off the selling position.

The intention of the investor or the trader is to make profits on account of anticipation of a price drop in the target security. Such transactions are quite common and a very popular trading strategy in case of a downward trend or the anticipation of the reversal of an uptrend.

Short selling was banned in India for a while but was then allowed in 2008 for the retail and institutional investors segment.

Short Selling Explained

a)Short selling involves borrowing a security from the broker, whose price is expected to fall by the trader.
b)The security is then sold immediately by the trader, in the hope that once its price drops, the same number of shares can be bought to ‘close’ the short position and pay back the borrowed amount to the broker.
c)The difference between the ‘sell’ and ‘buy’ price will be the trader’s profit.

Example

For example, a trader borrows 100 shares of a stock trading at INR 500 per share and sells them immediately for INR 50,000 (100×500). The stock price declines to INR 400 per share, when the trader purchases 100 shares to replace the ‘borrowed’ shares. The difference, that is INR 10,000 will be the trader’s profit.

Features of Short Selling

Features of Short Selling are:
1. Short Selling comes with a high risk to reward ratio and traders can either book profits or incur huge losses, if the price moves in the opposite direction.
2. Short-sellers try to profit from falling prices as per the current market situation as opposed to long-term investors who buy stocks to profit from their future rise in prices.
3. Short selling is used for ‘speculating’ or as a risk covering or hedging strategy.

Risks of Short Selling

Some risks of Short Selling are:
1. If prices go in the opposite direction, apart from paying back the borrowed amount to the broker, a trader is liable to pay interest as well.
2. Short selling is basically ‘betting against the trend’ which requires experience and expertise. Not everyone can use short selling as a profitable strategy.