What is Short-Selling, and how does it work?

As a stock investor, if you expect the stock price to surge, you’ll either buy the stock and hold it back in your demat account or buy the futures. But what if there is a negative view of your invested stock? In this case, you can sell those futures or buy a put option. If no stock is available on the F&O, the best option is short selling.

However, many new investors lack knowledge of what exactly it is and how it works.

What is short selling?

In short selling, an investor strategically borrows stock shares they expect to lose value, sells them at market value, and then buys them back at a discount.

The investor returns the shares to its lender to complete the short sale, keeping the buy-sell price difference. Investors may earn significantly if the stock price falls, but they risk limitless losses if it increases.

Some facts you must know about short-selling shares

• In short selling, the seller borrows shares from another owner to sell, as they do not own the shares.
• Only institutional and retail investors are allowed for short selling.
• Short selling is based on speculation.
• When engaging in short selling, the seller speculates on a price decline and may suffer losses if prices increase. 
• Upon settlement, traders have an obligation to return the borrowed shares to the owner. 
• Investors must disclose their intention to conduct a short sale as part of the transaction.

What is the purpose of engaging in short-selling stocks?

• Speculating: To profit from a stock’s decline, stock market investors or speculators short-sell by finding what they perceive to be an expensive stock. 
• Hedging: Hedgers sell stock to reduce the risk associated with their other long positions in the market. Hedgers prefer to protect gains on other long-position investments in their stock portfolio by making money from a short sell. 

How does the short selling work?

Selling a stock short involves purchasing it back just before the trading day ends. You get an overall time of 5 to 6 hours. Short selling consists of three steps-

1. You must choose the MIS (Margin intraday square-up) option to inform the system about the short-selling order when creating the sell order.
2. An intraday order requires margin payment. However, you can lower the margin by using the Cover Order (CO) step. You can add a stop loss to a CO and a stop loss and profit goal to a BO.
3. Orders for intraday short sales must be closed out on the same day by law. Around 3:15 pm, brokers perform an RMS (Risk Management System)  check and automatically shut out open orders.

Scenarios after short-selling shares

When you sell the stock, the value decreases. When you engage in short selling and the stock price goes up, setting a stop loss will automatically close your position. To minimise losses, you may choose to stop out early.

After placing a short sell order, there will be no activity in your stock for the first four hours. To avoid the volatility in the last hour, you may opt for a closeout.

What are the risks involved in short selling?

• Timing error

Although stock prices might not drop immediately, a trader is still responsible for paying interest and margin while he waits to profit from the stock price.

• Borrowing money

Margin trading, often known as short selling, is when a trader borrows a collateralised asset from a brokerage.

• Returning Security

The seller must prioritise returning the security amount to the owner within the allotted time frame.

• Regulations

Even though market regulators allow short selling, they are subject to a prohibition in a particular industry at any moment to protect investors.

Benefits of short-selling

• Gives investors market liquidity, which could lead to lower stock prices, better bid-ask spreads, and help with price discovery.
• Ability to lower total market exposure and hedge existing portfolio’s long-only exposure.
• The manager can use capital gains from short sales to overweight the long-only portion of the portfolio.
• Exposure to long and short positions can reduce the overall volatility of a portfolio and increase the potential for significant risk-adjusted returns.

Conclusion

Short selling in the stock market isn’t for fresh investors or traders. It is important to learn the basics and then head over to the process.

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