Simply put, short selling means selling stock/security that the seller does not own. In a short sale the investor borrows securities/stocks and sells them with an intent to buy the same stock/security at a lower price in the future. Typically short selling is used in the bear market to make profit as the stock prices decline.
How Short Selling Works
- As mentioned above, in a short sale the trader does not own the stock that he is selling.
- The trader borrows shares with the help of a stock broker and sells it at the market price with an expectation that the price of the stock will fall.
- When the price of the stock falls, the investor buys the stock at the lower price and books profit.
Let us understand the concept with an example. Vijay is a trader. He expects the stock price of company ABC to fall to Rs 1,500. The current stock price of ABC is Rs 1,800. Vijay does not own any stock of this company. Vijay sells 100 shares of ABC through his trading account with the broker at Rs 1,800 after the stock market opens. This creates an open trading position.
As expected, the stock price falls to Rs 1,500. Now Vijay buys 100 shares of ABC at Rs 1,500 and closes the open position on the same day before stock markets close. In this transaction Vijay has made a profit of Rs 30,000 i.e. sale amount of Rs 180,000 (1800*100) – buy amount of Rs 150,000 (1500*100).
Benefits of Short Selling
- Correction of irrational stock prices.
- Results in higher liquidity in the stock market.
- Can be used to hedge downside risks related to securities.
- Margin maintenance, brokerage are the only things required to execute a short sale.
Disadvantages of Short Selling
- There is a potential of unlimited losses in short selling as the shares are sold already and the stock price can increase or decrease. If the prediction goes wrong, the trader may have to bear massive losses.
- The shares are borrowed in a short sale. The trader has to maintain adequate margin which fluctuates based on the share’s market price. The trader may have to add funds in the margin account due to these fluctuations.
- Short selling is time sensitive. If the trader does not close out his position in time he may not be able to make a good profit from the trade.
To conclude, short selling is entirely based on speculation. If done correctly, there is a potential to earn huge profits with low investment. Short selling is ideal for seasoned traders and investors. It is not ideal for beginners or people who are new to stock trading.
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