Share trading online is considered a lucrative mode of investment globally. But most investors think they can book profits only when the price of the stock they have bought is rising. In reality, though, the volatility in the market makes it difficult to predict trends accurately. Investors should, therefore, be aware of the various share-trading techniques for optimizing returns from investment. One such trading strategy is short selling.
What is Short Selling?
Short selling, or going short, is a trading practice implying borrowing shares and selling them in the open market.
While undertaking a short-selling strategy, traders look for shares that are overpriced or not performing well. When an investor borrows the overpriced stock and sells them to willing buyers at the market price, betting on their price to decline before he has to return the borrowed shares, when that happens, the investor repurchases the shares, hopefully at a lower price, returns them to the original holder and pockets the difference.
Let us consider an example.
A trader expects that company A’s stock price, which is currently trading at Rs 100, will decline in a week after, say, the company announces its results. So the trader will borrow 100 shares from a broker and “shorts” those shares, which he doesn’t own, to the market in the hope that prices decline. He sells those shares in the open market at the current price.
When the prices fall in a week to, say, Rs 80, the investor will close the short position by repurchasing the 100 shares from the open market and then returning them to the broker, making Rs 2,000 in the transaction before commissions and interest.
Key Features of Short Selling
- The investor does not own the shares they are selling. They borrow it from another share owner.
- Both retail and institutional investors can conduct short selling.
- Speculation forms the basis of short selling.
- While short selling, the seller expects the prices of a particular stock to decline. If the prices rise, the investor will incur losses.
- At the time of settlement, traders need to return the shares to the owner.
- Investors need to disclose the transaction as a short-selling transaction.
- A short selling strategy is mostly applied in a bearish market when the chances of a substantial price fall are high.
What makes Short Selling popular?
Two main reasons why investors find short selling attractive are speculation and hedging.
Pros and Cons of Short Selling
Pros
- Provides better liquidity
- Allows hedging risk
- Exposure to both long and short positions helps minimize portfolio volatility.
Cons
- Less liquid stocks may be expensive, making borrowing difficult
- Market manipulators could deflate stock prices, increasing volatility
How Does Short Selling Work in India?
The Securities and Exchange Board of India (SEBI) regulates the trading of stocks. SEBI allows traders equity short selling only as an intraday trade. This implies that you can borrow from your broker for only one day as a trader. If you fail to buy back the shares before the trading day’s close, then your broker square-offs the position on your behalf. So, SEBI does not allow you to carry your equity short-selling position forward.
Short selling based on speculation expects share prices to fall before they are returned to their owner. Because of its high risk-to-reward ratio, short selling is used mainly by experienced traders and investors.
