Short Selling Explained – What is Short Selling in Stock Market?
Understand What is Short Selling & Its Implications: The terminology ‘Short Selling’ is frequently used in the capital market. It has also been a lot more talked-about on news in recent days because of the SEBI vs Mukesh Ambani Case. SEBI has imposed a penalty of Rs 25 Cr on Reliance Industries and Rs 15 Cr on Mukesh Ambani for manipulating the settlement price of Reliance Petroleum Ltd on 29th November 2007, by shorting nearly 2.7 crore shares, 10 minutes before the closing of the day. This led to a sharp decline in the share price of RPL and investors losing money in the market.
In this article, we are going to discuss exactly what is Short Selling, how market participants make money by short selling, its pros, cons, and more. Let’s get started.
What is Short Selling?
As the name might suggest, Short Selling must have got to do something with the selling of underlying security. In the stock market parlance, short selling would simply mean the selling of shares of the company before buying them i.e. selling shares of the company without having their ownership. Retail and Institutional investors are permitted to short sell.
In other words, the investors or traders are selling equity shares that are not owned by them (i.e. not available in demat account) lent by their brokers with a promise that they will be delivered back to the broker at the time of settlement.
As traders are selling before buying, the short selling concept is entirely opposite of regular investing (where we first buy and sell). And hence, Short sellers make money when they buy back the stock at a lower price. The difference in the selling price and the buying price is the profit for the short-sellers.
Short Selling Explained
Let us try and understand the concept of short selling with the help of a case-based scenario. Say, Mr. X is a regular trader in the market and he has got a bearish (pessimistic) stance on the share price of State Bank of India (SBI), and his view is supported by the following factors:
- There is a bearish candle formation in the market (say, Bearish Marubuzo).
- The high of the previous day is intact and the market is trading below it.
- There is a significant increase in the selling activity in the market as compared to previous days.
- And there are other news-driven factors that could have a negative impact on the share price of SBI.
Owing to the reasons mentioned above, Mr. X believes that the price of SBI may fall. He is expecting the immediate support levels to be tested in the market (4% below the current price levels). Therefore, to take advantage of this expected bearishness in the market, Mr. X decides to short the shares of SBI. Let us understand this trade:
|Share or Stock||State Bank of India|
|Type of trade||Shorting or Short Selling|
|Shorting price||Rs. 300|
|Quantity of Shares||500|
|Profit Target (4%)||Rs. 288|
|Stop Loss||Rs. 305|
|Total Risk in the trade (500*5)||Rs. 2500|
|Total Reward in the Trade (500*12)||Rs. 6000|
|Risk – Reward Ratio (2500:6000)||5:12|
If the share price of SBI falls in accordance with the views of Mr. X, then he stands to make a gain of Rs. 6,000 on his trade. On the other hand, if the market goes against his views, he loses Rs. 2500 on his trade.
Why do Traders Short Sell in the Market?
Here are a few of the key reasons for the traders to Short sell stocks in the market:
— To Speculate: This is one of the primary reasons why does one takes a short position in the market. If one is of the view that the strength in the market is about the fizzle out and we could see some correction or weakness in the market, they will short sell.
— To Hedge: Hedging as a strategy is of prominence in the capital market. If one is having a bullish view on the market over the long term but is expecting a small correction in the market on its way up, they might short sell. Here, traders short sell to play that short-term weakness in the market, one takes a short position in the market.
— To improve the entry point: This is one interesting rationale behind short selling used by experienced traders. Say, if Mr. A is willing to buy 1,000 shares of ICICI bank at Rs. 250. The current share price of ICICI Bank is Rs. 270. Now, he ends up buying the shares of ICICI Bank at Rs. 270 each. Now to improve the entry point for shares of ICICI Bank, Mr. A shorts (sells) the shares of ICICI bank whenever he sees weakness in the market and books a small amount of profit and improves the entry point of the initial purchase of ICIC bank shares.
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Rules Regarding Short-Selling in Stocks
Shorting in the cash market comes with its own set of rules and regulations. It has to be strictly done on an intraday basis i.e. the position cannot be carried over to the next day. Therefore, whenever we sell before buying in the spot market, the position has to be bought back before the end of the day.
The short position cannot be carried over to the next day. Nevertheless, position carrying is permitted in the F&O market and to facilitate this, the exchange already keep margins in the Demat or trading account to account for Mark to Market (M2M) losses.
Advantages of Short Selling
Despite being a subject of controversy, short selling is a very important phenomenon to maintain balance in the capital market. The following are some of the advantages of short selling:
- Short selling helps in correcting the irrational overpricing of the stocks
- It provides liquidity in the capital market.
- Short selling prevents the sudden rise in the price of the stocks which are fundamentally weak/
Drawbacks of short selling
Here are a few major drawbacks of short selling in the stock market
- Short sellers might be exposed to higher risks compared to regular buying and selling.
- Manipulators often use Short selling as a method to hurt the price of certain stocks which has a direct bearing on the market sentiment.
- It can sometimes also be used to benefit the counter position taken in the F&O market.
In this article, we discussed what is Short selling along with its advantages and disadvantages. Short selling simply means selling shares of the company that one does not own. By doing so one is exposed to higher risks in the market but it has the potential of earning high returns. In recent COVID-19 pandemic times, the ability and the understanding of the concept of short selling went a long way in earning handsome returns for the traders and investors.
That’s all for today’s Market Forensics. We hope it was useful for you. We’ll be back tomorrow with another interesting market news and analysis. Till then, Take care and Happy investing!
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Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!