Many beginners get confused when they first get to know about short-selling. They ask with a confused voice “how can you sell something that you don’t have/possess?” Well, that’s what I am going to attempt to explain in this post.
We are going to learn what short selling is and how it works, and I will attempt to answer more frequent queries related to short selling.
So, first thing first…
What’s Short selling?
Short Selling (or going short) is a technique used by traders to profit on a falling stock price by selling borrowed shares when the fall is happening and buying back at a lower price.
In other words, short selling is the exact opposite of buying low and selling high, i.e., you first sell at a high price and then buy back at a lower price.
In the case of short selling, the investor/trader profits from the decline in stock price. The difference between the buying price and the selling price is the profit.
Understanding short-selling | Example
Let’s suppose your analysis of a stock named Z indicates that Z might fall now after a good upward swing. A conventional trader might just wait for the downward swing to end so that he can enter again for a long trade and make a profit when the price goes up again. But what if you could make money in a falling market too!?
By short selling, you can profit when the price is falling. Let me explain with an example how this works.
When you are shorting (short selling) a stock, you basically borrow shares from your broker and sell them in the market and buy back when the price falls even more.
Let’s suppose Z is trading at ₹50 and you speculate that the price of Z is going down from here. In this case, you place a Sell order for 100 quantities of Z in your trading platform for a total of ₹50 x 100 = ₹5000.
Now suppose, by the end of the trading session, the price of Z reached ₹45 and you bought back 100 quantities of Z at this price for a total of ₹45 x 100 = ₹4500.
Thus you make a profit of ₹500. Profit = Selling Price – Buying Price.
Just the only difference was that you sold first and bought later, the exact opposite of the conventional way of buying first and selling later.
You might ask, what if the price went up instead of going down after I short sell? Well, in that case, you make a loss. Suppose, in the previous example, if the price reached ₹55 and we close our position at this price by buying back 100 quantity, our loss will be ₹5000-₹5500 = -₹500 (Selling Price – Buying Price).
How risky is Short-selling?
Theoretically, the risk is amplified when you are short-selling compared to buying a stock.
When you buy a stock, you make a loss if the price goes downwards. In this case, theoretically, there is a limit to how much it can go down. It can go down to zero, so there is a limit to your losses in this case. In the worst case, the stock price will come to Zero and you lose the total value of the stock as your loss.
On contrary, when you short-sell a stock, you make a loss when the price goes up. In the case of buying there was a floor for your loss at zero, but in this case of short selling the price can go up and up and there is virtually no limit to it. Thus your loss has no ceiling to cap it. So technically, short-selling comes with the possibility of infinite loss.
That’s why it is not advisable to short-sell or take any kind of trade without placing a Stop-loss order. In practical situations, you can minimize your risk and cap your losses by placing a Stop Loss order whenever you’re short-selling.
Do i have to pay any interest when borrowing shares for short selling?
That depends on where you are located. In most countries, there is an interest you need to pay to your broker for borrowing shares depending on the time you take to cover your position.
In India, there are no additional charges when you are short-selling a stock. You don’t need to pay any interest to your broker for borrowing shares.
For how long can I short a stock?
Again, that depends on where you are located. Stock exchanges in a few countries allow you to carry your short position overnight for days. In India, you need to square off your short positions by the end of the same-day trading session. Indian exchanges do not allow short positions to be carried overnight. Delivery-based short selling is not allowed in India, you can short sell only in Intraday sessions.
If you want to short any security for more than one day, you need to short through different instruments like Futures and Options. More on Futures and Options in coming blog posts.
When does short-selling make sense?
Short-selling makes more sense when we are in a sideways range-bound market or a downtrend market. As a trader, you do not want to be just sitting around when the market is in a downtrend. We, as a trader, can make a profit even in a downtrend falling market by short-selling. Of course, you should have a conviction on the trade through your analysis of the stock before taking a short trade.
How do I borrow the shares for short-selling?
You don’t have to be doing any additional steps to borrow shares for short selling. This borrowing from your Broker happens instantly on the backend when you place a sell order on your trading platform. This is a seamless process with no additional step on your side, similar to a Buy order.
Key Takeaways
Short selling is a great way to earn profit in a range-bound or down-trending stock. It also carries, theoretically, an infinite loss possibility. Short selling is well suited for day and swing traders for making a profit in the short term falling markets.
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