How does Short Selling in Stock Markets work?
A large number of traders bet what goes up must come down. While inexperienced traders often stick to the objective of buying low and selling high in the stock market, traders who believe in going short recognize that selling high and buying low can be just as profitable! To simply state, short selling is making a prediction that the price of a stock will go down rather than up. Let us explain how this works.
In a normal scenario, traders buy or sell securities that they already own. In other cases, the trader may borrow some securities (like stocks) and sell them. This is called short selling. The trader sells the shares he does not own at the time of the sale. The trader does this by borrowing securities from a broker and selling them in the market, hoping that the prices of the stocks would fall so that the trader can eventually buy them again at lower prices and return them to the lender. This way, the trader profits from the price difference between the high selling price and low purchase price.
Let me explain this to you by an example: An investor believes that the price of stock Z, which now trades at $500, will decline when the company announces its annual earnings after a week. The investor then borrows say 100 shares of stock Z for $50,000 from a broker only to short sell them in the market. A week later, when the company announces its annual earnings, the stock price falls to $400.
The investor then closes his short position and buys 100 shares of stock Z from the open market at $400 per share i.e. for $40,000 and returns them to the lender. This is called a buy-to-cover order. The investor, therefore, earns a profit of $100 per share and $10,000 from the whole transaction if we exclude the commission and interest payments.
To open a short position, a trader must have a special brokerage account called the margin account in which the broker lends cash for the purchase of stocks or financial products. Investors have to pay interest on the value of borrowed shares while the position is open. In India, SEBI regulates and governs the brokers and broker-dealer firms. SEBI also specifies the minimum values that must be maintained in the margin account, known as the maintenance margin. If the account balance falls below the maintenance margin, more funds are to be added to the account to meet the maintenance margin requirements otherwise the position might be sold by the broker.
Traders must also pay for any interest or commission charged by the broker. The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be done through the regular trading platforms with most brokers.
This strategy is usually followed by investors who have a knack for speculating. In this case, the speculation is that the prices of shares would go down at which they would borrow and later they would pay off their debt by selling at a higher price.
On the other hand, investors also use short selling to hedge risk. An investor already holding a long position in the same or related security prefers to short sell it in order to protect himself from downsides of risk. Short selling happens in bearish markets when the chances of price drops are extremely high. Traders have to disclose that the transaction is going to be a short sale and honour their obligation to return the shares to the lender at the time of settlement irrespective of the profits or losses he incurs.
Since short selling is largely based on speculation, it might lead to infinite losses instead of profits. When a high number of investors decide to short sell the shares of a particular company, the share price of that company, as well as the entire market in general, are adversely affected. It may cause the company or the market to destabilize. Due to these reasons, short selling is highly regulated. In India naked short selling, i.e. shorting shares with no intention on part of the investor to make delivery of the shares he sold, is banned. The investor must show proof of borrowing and honour his obligation of making a delivery at the time of settlement.
While short selling is essentially betting against the market momentum, financial experts have often argued for short selling as they believe it provides liquidity, helps correct irrational overpricing of stocks, and prevents the sudden rise of bad stocks. Short selling is not for inexperienced traders and speculators who are not aware of the inherent risks in the activity. Only those who truly understand the markets and have complete knowledge of market dynamics should practice short selling
Written by – Neha Haldia