Introduction To Short Selling
It is ordinary for traders to earn money when stock prices rise. But there is a way in which the traders benefit when the share prices decrease. It is through the method of short selling.
Short selling is a method of trading in which the investor sells the shares he doesn’t own by borrowing them. But how do you sell something that is not owned by you? It can be done through margin trading where it acts as a security with the broker. Shorting is for the short term rather than a long term.
Example: Let us assume that the share price of company X is Rs.500. An investor (who doesn’t own the shares) believes that this price will fall in the future. So, he borrows 100 shares with a pledge to return them later and sell them for – Rs.500 * 100 = Rs.50000
As predicted by the investor, the price plunged to Rs.450. Then the investor will buy the 100 shares he has to return to the owner at Rs.450 * 100= Rs.45000, earning him a profit of Rs.5000 (Rs. 50000 – Rs. 45000).
History Of Short Selling
Short selling was first practiced in the 1600s by the Dutch Stock Exchange. It is believed that Issac Le Maire, a merchant who owned major shares of the Dutch East India Company, was short-selling the stocks and was blamed for the crashing of the market in 1910.
Further, in 1929, the year of the Great Depression, they were blamed for the stock market crash.
During the financial crisis of 2008 and the Coronavirus Pandemic, it was banned in many countries.
SHORT SELLING IN INDIA
This trading technique was banned in India from 2001 to 2008 because allegations were made against Anand Rathi, the then president of BSE, of insider trading and the use of sensitive information to make trades. Later he was cleared by SEBI of any wrongdoing.
In 2008 SEBI allowed individual and institutional investors to start trading in short-sell.
When Coronavirus spread, it was again banned from March 2020 to October 2020 to prevent the market from falling.
HOW DOES SHORT-SELLING WORK
The short sale of stock happens in a span of an intraday. The investor has the time limit of the trading hours, i.e., if he has decided to short-sell a stock, he needs to sell and then buy the store on the same day whether the price increases, decreases, or remains stagnant. While making an order he needs to select Margin Intraday Square off (MIS) which tells the system that it is a short sell.
Three scenarios can happen during shorting:
- If the price decreases, it will benefit the investor as he sold at a higher price and bought at less.
- If the price increases, it will create a loss for the investor as the stocks he sold were borrowed, and it has to be bought on the same day, resulting in a loss.
- If the stock price does not change during the day, it may cost the investor brokerage fees (which would be a loss for him).
WHY TRADERS DO SHORT SELLING
Some traders short a stock mainly to engage in speculation and hedging.
The investor speculates that the price of a stock will decline in the future, he will sell the shares at this high price and will purchase again when the price falls and return them to the lender. Another reason why people short a stock is to hedge stocks where they have long positions in a related business. To avoid risk, he short-sells to gain profits.
NAKED SHORT SELLING
This type of short selling is banned in most countries as it is deemed illegal. It involves selling shares no one owns, and there is no indication that they even exist in the market.
- Very little capital is required as it follows the method of the first sell then buy.
- It makes a profit when the market is bearish compared to other investment forms.
- They help in the price correction of the overvalued stocks.
- It brings liquidity to the market.
- When there is a negative view on a stock then also profit can be made even if you do not own it.
There are several risks in shorting as its ethics are questioned, and whenever there is a problem in the economy, it is banned in the country. Some of the risks are:
- In short selling, the stocks are borrowed, which have to be repaid in a period specified.
- It is all about the timing of the selling and buying take. If the timing is bad, they may make a huge loss.
- It is purely based on speculation, and if the trader makes losses, they would be infinite with no limit.
- Sudden changes in the market rules and regulations about shorting can also work against the traders, which may incur a loss.
Short Selling is said to be dangerous in the stock market, if done heavily on any stock may result in the downfall of the stock and the market. There are many restrictions in shorting a stock on the type of stock, the size, and the price at which it can occur. If the market is volatile there is a chance that short selling is banned in the country.
Short selling can be the most profitable when the market is bearish. It is built on the speculation that the stock prices will soon fall, but it can give the traders a massive loss if they are wrong in their assumption. It comes with a very high amount of risk, but as it is said: Higher Risk results in High Rewards.
Shorting many a time triggers the question if it is ethical and within the rules of trading. Many investors are against this practice. Short-sellers are often blamed for starting or prolonging the financial crisis. But if the intents of the traders are good, then it can be said that it is a part of the system as it provides liquidity and is known to bring down the share price of overvalued shares.
But there is a negative side to shorting a stock as well. A handful of traders manipulate the share market and may spread false news regarding the company whose share they want to short.
Frequently Asked Questions:
What will happen if a trader short-sells a share but fail to deliver it on the same day?
If the Equity Short is not squared off by the end of the trading day because of any reason, it is called short delivery. After the seller defaults, an auction will take place on T+2 days, where the seller has to pay a high amount to buy the same share.
Why do some people hate short sellers?
It only makes money when the prices of stock decline, and earning profit from someone’s loss doesn’t sound right.
What is Short Squeeze?
It is a situation in which many investors sold short stock of a company but instead of the prices going down they increase.
Can Short sellers destroy a company?
A group of short sellers may operate in the shadows while spreading negative rumurs to bring the share prices down just to profit.