Short Selling: Definition, Pros, Cons, and Examples

What is Short Selling in the Stock Market?

Short selling is a way to earn money in a falling market, more specifically when the share prices are falling.

If you’re new to trading and the stock market, this concept can feel complicated to understand. Hence, we’ll take you through short selling step-by-step.

The first thing you need to understand is how buying a stock works in the traditional sense.

You buy a stock typically based on two things - market analysis and when you feel the share price will rise. Once it does rise, you might choose to buy more, hold and eventually sell it for a profit margin. The higher the profit margin, the higher the return on your investment.

As you can see, this is the traditional sense of ‘buying and THEN selling’.

Short Selling is pretty much doing the exact opposite - where you first sell and THEN you buy again.

This gets slightly complicated so bear with us. But to understand how this method works for you, let’s take you through the example.

Example for Short Selling in India.

Let’s say you hold 60 shares for XYZ company on hand, the share price being ₹1000. Based on current trends, you’re certain that the stock for XYZ company is going to fall to ₹900-950.

You then sell the shares (60) based on its current price (₹1000/share). When it falls to the lower limit (₹900), you purchase the shares again.

Therefore,

Sell at: 60 x 1000 = ₹60,000

Buy at: 60 x 900 = ₹54,000

As you can see in this example, you’ve made a profit of ₹100 on each share by selling and then buying again at a lower price. And short selling these 60 shares gives you a profit of ₹6,000.

So remember,

Sell when high.

(and)

Buy when low.

But short-selling is not as straightforward as the previous example.

A question that is likely to have come to mind is “Where do these shares you can ‘sell’ come from in the first place?” Well, these shares are borrowed and need to be returned on the same day - through intraday trading.

But now you’re thinking:

Is Short Selling even legal in India?

While some countries have banned it, SEBI has put forward regulations traders need to abide by. As long as it’s done within the same day through an intraday settlement, Short selling in the Indian stock market is legal.

All you need is an MIS (Margin Intraday Square-off) Account or if you’re doing it through a third-party app, see how the broker allows for it.

It works a bit differently in the US as you’ll see here .

How does Short Selling work?

As we previously mentioned, you don’t need to hold these shares you want to sell and that’s the beauty of short selling.

So why would you be allowed to ‘borrow’ these shares in the first place?

Because when you do short selling, you need to finish your transactions within the same day. The biggest disadvantage to it is the ‘risk’ you need to take up.

That risk can equal a profit or a risk, depending on how well you can analyse the stock market which is risky even when you do the basic buy and sell.

What happens when you fail at Short Selling?

Our previous example showed the more positive side to short selling. But what happens when the share price increases?

The current share price for XYZ is ₹1000. You borrow 60 shares of the company.

But its share price ends up increasing to ₹1040 per share.

So essentially, that difference is a loss of ₹40 per share.

That difference of ₹40 x 60 shares = ₹2,400 is the total loss you incur.

That loss is the risk you take up when you do short selling.

And if you’re thinking, “ Ha, I’ll just hold these borrowed shares until the price lowers.”

Well, my friend - that’s when short selling becomes illegal. Given that these are borrowed shares that need to be an intraday settlement, it’ll automatically be squared off when the market shuts. If you do this through a broker, most shut off orders up to 30 minutes before the market closes.

At the end of the day, short selling is not something an amateur trader can do and requires a thorough understanding of the financial market. And remember, the stock market has its whims - be sure to know the risks associated with it because it could very well be a gamble.

To conclude:

Short selling is a way to make money when share prices are falling in the stock market. It involves selling shares you don't own and then buying them back at a lower price to make a profit. Short selling is legal in India as long as it's done through intraday trading and using a Margin Intraday Square-off (MIS) account. However, short selling involves risks and requires a thorough understanding of the financial market.

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