How does short selling work?
In the financial market, short-selling is based on market speculation and contains significant risk. Typically, only experienced investors and traders can comfortably take the risks and try to benefit from this strategy. In short-selling, a trader first sells the shares they borrow from a broker. These shares are not owned by the trader and are simply borrowed. From this position, the next step is to wait for an anticipated drop in the share price. This is because the shares have to be bought back to return to the broker and close the open position.
In this strategy, traders benefit from the price difference between the buying and selling price of stocks. However, the shares are sold first, and traders wait for a price drop to buy them back. As mentioned earlier, there always exists a big risk that the share price will not drop and may even increase. This can lead to significant losses for traders and investors. In addition to capitalising on speculation, fund managers and investors also leverage short-selling measures to manage the downside risk involved in maintaining a long position on their assets.
One of the specific prerequisites of short-selling is the margin account, which has to be utilised to borrow shares from a broker. In this account, a margin amount must be maintained to continue holding the position. Keep in mind that this only applies to cases where you borrow the stocks from a broker. A margin account is not required when fund managers or investors look to protect a long position from potential losses and downside risks.
Factsheet of short selling
Detailed below are noteworthy features of short selling:
- While institutional and retail investors can short-sell, the sellers are not the share owners. They borrow it from a different owner.
- With short selling, the seller takes advantage of a price drop. They shall face losses if the price rises.
- Generally, short selling occurs in a bearish market when the chances of a price drop are significantly high.
What are short selling metrics?
There are two key short-selling metrics that investors and traders rely on to analyse and identify overvalued stocks. These are:
1. Days to cover ratio
This ratio is used to analyse the interaction of the total number of short stocks and the present trading volume of the share. It can also be expressed as the ratio of short interest to volume. Traders rely on this to understand the demand for a stock, with a high ratio signifying a bearish trend.
2. Short interest ratio
This ratio helps traders understand the relation between the number of shorted stocks and the number of currently afloat stocks in the financial market. A high short-interest ratio is a possible sign of an impending price decline in the given stock. This also worsens short-squeeze possibilities.
Benefits of short selling
Listed below are the benefits of short selling:
- Short selling ensures liquidity in the market resulting in lower stock prices, improves bid-ask spreads, and helps in price discovery.
- The only requirements that a person needs to execute short selling are margin maintenance, commissions, and dividend.
- Exposure to each of the long and short positions reduces portfolio volatility. Moreover, there remains a probability of substantial gains if the prediction of a price decline comes true.
Drawbacks of short selling
Here is a list of the problems of short selling:
- Financial experts consider short selling to be quite volatile, and there remains the probability of losses without a limit. There is a high risk associated with this strategy because stock prices change rapidly.
- Lenders may recall the borrowed stock at any time. Moreover, short sellers have minimum control over the price required to cover their position.
- Traders must have a margin account and pay a certain amount to make short sales.
If you are an experienced trader and looking to explore the short selling strategy, it is vital to have a Demat account. Bajaj Financial Securities Limited stands as a reliable choice for investors seeking to open a Demat account with abundant features and complete safety.
Risks of short selling
While profitable under the right circumstances, short selling also involves the following risks:
1. Difficulty of timing the market
The success of a short-selling strategy entirely depends on precisely timing the buying and selling of stock. If you delay shorting a stock, there may be a good chance that it has lived out most of its price fall.
2. Potential for unlimited losses
Shorting can lead to losses if stock prices rise instead of falling as anticipated. The potential for loss is infinite since there is no ceiling on how much a stock price can rise.
3. Margin interest
Traders engage in short selling by borrowing from their brokers. They are liable to bear a certain interest on the borrowed stocks and maintain the margin. If you fail to maintain the margin, your broker may ask you to add more funds or liquidate your position, leading to losses.
4. Unwise selections
Short selling involves rooting against companies or the overall market. Selecting the right stocks to short is the key to making profits from a short sale. Choosing the wrong company to short can result in losses for the trader, while others gain with a long position.
5. Risk of short squeezes
Short squeezes happen when traders try to buy back stocks that have been heavily shorted. A sharp rise in the price of this heavily shorted stock prompts traders to buy it back to minimise losses. Each wave of buy back increases the stocks price even further, resulting in greater losses for traders holding onto a short position.
6. Regulations
Short selling is completely legal in most countries, including India. However, market regulators may restrict or prohibit short selling in particular sectors or the entire market to avoid panic and limit selling pressures.
Why sell short?
Short selling is a strategy used in trading for two main reasons. First is predicting price movements. A trader may predict that the price of a certain security will decline in the future; and so if they are wrong, they will have to buy the shares back higher, at a loss. However, this strategy involves higher risks, and it's crucial to be cautious and well-informed before implementing it.
The second reason for short selling is hedging, which involves selling short to hedge a long position. This helps lock in profits and limit potential losses.
When is short selling profitable?
The short-selling method can be profitable if done right. It is important to be confident about speculation and patient while waiting for the price to drop. When the prices fall, you can profit by buying the security at a lower price than what it was sold at.
Let us take an example of a situation when short-selling can be profitable. Rashmi believes that the stock ‘XYZ’ is overvalued, currently trading at Rs. 100. They expect that when the company declares its financial reports in a couple of weeks, its stocks will decline sharply. To benefit from this speculation, they borrow 100 stocks of the company to short sell them at the current price of Rs. 100. After waiting patiently, when the financial reports are released after two weeks, the speculation turns true, and the stock price falls by Rs. 20 to Rs. 80. At this price, Rashmi repurchases the 100 shares, making a profit of Rs. 20 per share. Their overall profit earned from short-selling, in this case, is Rs. 2,000 as they return the shares to the lender.
In reality, even after reaping a profit of Rs. 2000, Rashmi may have to pay more charges. This includes commissions, borrowed stock interest, and possibly a dividend payment to the buyer of the stock.
In addition to these conditions, if many traders short the same stock, it can cause a shortage of available shares. This would, in turn, raise borrowing costs. However, there is no guarantee of finding buyers and sellers later in the market, even after borrowing.
Example of short selling for a profit
Let’s say you believe that the price of a particular stock is going to decline. You borrow shares of that stock from your broker and sell them at the current market price. Later, when the price of the stock falls as expected, you buy back the shares at a lower price and return them to your broker. The difference between the selling price and the buying price is your profit.
When does short selling result in loss?
Short-selling can result in a loss when the speculation of an investor does not come true and the price of the shorted stock goes up. What makes this situation worse is that, theoretically, it is possible to lose an infinite amount as the prices can go infinitely high.
In traditional trading, stocks are bought at the market price with the expectation that the price will soon increase when they can be sold for a profit. This is less risky compared to short-selling, as you can only lose to a certain extent. While there is limited risk in traditional trading, there is infinite or unlimited risk in short-selling.
Let us also illustrate the loss-making potential in short-selling with an example. Suppose Aarti decides to invest in the shares of the company ‘MNO Ltd.’. As they expect the stock price to fall from the current value of Rs. 500 per share when the company comes out with its annual financial report in a month, they decide to borrow and short-sell 10 stocks at the current market price. With the announcement of the financial reports, it is also revealed that the company was bought by a bigger and more reputed company, ‘ABC Ltd.’, and will soon merge with it. Despite a not-so-great financial report, this news is received positively by the market, causing a price jump in the share price to Rs. 550. This is a terrible move considering Aarti’s short position at Rs. 500. Nevertheless, they decided to repurchase the shares at Rs. 550 to close their position and cap the loss at Rs. 500, besides the commission and interest that may be charged on the trade.
Example of short selling for a loss
Conversely, if you short sell a stock and its price rises instead of falling, you may incur a loss. For instance, you borrow shares of a stock from your broker and sell them at the current market price. However, if the stock’s price increases instead of declining, you will need to buy back the shares at a higher price to return them to your broker. The difference between the buying price and the selling price represents your loss.
Example of short selling as a hedge
Short selling can also be used as a hedging strategy to protect against potential losses in an existing long position. For instance, let’s say you own shares of a company and anticipate that its value might decline in the near future due to certain factors. To hedge against this potential loss, you can short sell an equivalent number of shares in the same company. If the stock’s value does indeed decrease, your short position will offset some or all of the losses incurred on your long position.
Please note that these examples are for illustrative purposes only and do not constitute financial advice. It’s important to thoroughly understand the risks associated with short selling before engaging in such transactions.
What is Naked Short Selling?
When an investor shorts a stock without borrowing or making any arrangement to borrow it, it is referred to as a naked short sell. The trader will not be able to tender shares to the buyer if he/she fails to borrow them before the clearing period. He/she must close the position or borrow more shares. Until and unless he/she does that, the trade will be seen as ‘failed to deliver’.
Naked short selling is not allowed in many countries, including India, because it disrupts the regulations regarding demand and supply. It can create high market volatility if it is carried out in large quantities.
Can a person short-sell in delivery trading?
Intraday trading is allowed in the Indian market, but if a trader sells and doesn’t deliver the shares, his/her trade becomes a ‘short selling in delivery’. If a client purchases shares, he/she must pay the full amount and take delivery through his/her Demat account.
If the sale of shares takes place with delivery in mind, then one must deliver these shares to the exchange. In case of a failure, this delivery trade will become a short sell.
SEBI (Securities and Exchange Board of India) has defined short selling as selling a security or a share that a seller does not own. Experienced traders and seasoned investors engage in this advanced trading strategy. This is because short selling has a high risk-to-reward ratio. In other words, traders have chances of earning high profits and incurring great losses as well.
Difference between regular investing and short-selling
While short-selling can be an impactful method to make profits in the financial market, it has certain rules and regulations that make it significantly different from regular investing. One of the most prominent of these is the restriction on short-selling a stock which falls more than 10% in a day compared to the closing price of the last trading day. In addition, the risk of losses in short-selling is infinite, theoretically. This is because the price of a share could possibly increase and grow indefinitely. Thus, despite its impactfulness, short-selling is best leveraged by seasoned traders and investors who have the risk appetite for this method.
Conclusion
Short selling technique is not for naive traders, who are not aware of the inherent risks in the activity. Only those traders having detailed knowledge of stock market dynamics should practice short selling.
By carefully considering the strengths and risks of short-selling, investors can make informed decisions. If you are an experienced trader and would like to leverage this opportunity, open a Demat account and start trading.
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