What is short selling?

Short selling - a strategy where you sell a stock before buying it; sounds cool but it’s risky

Explaining short selling and the risks it carries

What do you do when you want to invest in the capital markets? You go to a broker, tell him or her of the company shares or the mutual funds that interest you, and the broker makes the necessary investments for you. The process involves you making an investment in the hope that the stocks will increase in value in future – often over several years or decades.

Short selling is quite unlike this; in fact, the process is just the opposite of what we generally do when buying a stock. Here, we sell a stock before you buy on the premise that its price will fall soon. In other words, we sell the stock first, and then we buy it.

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The concept

Sounds complex? Not really – short selling is a three-step process that works like this: the investor “borrows” shares from one’s broker, and sells them immediately in the open market. However, the process does not end with the investor pocketing the proceeds; he or she has to return the shares to the broker as well.

The next step involves waiting for the stock prices to fall so that it can be re-purchased at the lower price. The investor makes the profit after returning the “borrowed” shares to the broker and pocketing the difference between the price at which the stock was sold and the price at which it was bought. Let us try and simplify it further, using numbers:

Say you believe the share prices of Company A are going to drop, and smell a chance to make a quick buck through short selling. As you do not own any shares of Company A, you contact your broker and borrow 10 shares; please note, you have not spent a rupee till now. This is the first step.

The next step is to sell the shares immediately at the market price; you do that and get say Rs 1000 – i.e. at Rs 100 a share. At the same time, you have offloaded all the 10 shares that you had borrowed, and which have to be restored.

Let us assume that true to you hunch, share process drop – to say, Rs 80. Here comes the third step: you buy back the 10 shares for Rs 800 and return those to your broker, and pocket the profit (Rs 200) that you made selling higher.

Related: 5 Mistakes to avoid while investing in a bull market

Understanding short selling

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Margin money

Generally, “borrowing” of stock from a broker or an institution is difficult unless the investor is an individual with a high net worth or enjoys excellent understanding with the lender/broker. But despite the goodwill existing between the two parties, the broker expects payment for delivery of the stocks to be sold short. 

At the same time, it is advisable for the investor to have a “margin account” with the dealer concerned before the actual process of short selling can be initiated. When we talk of “margin account” or “margin money”, we are talking of the practice of borrowing money from the seller (the lender) to buy securities from the lender.

Under this practice, the buyer (the investor) pays only a percentage of the value of the asset when buying it, and borrows the rest from the broker, who then acts as the lender, the collateral being the securities in the former’s account.

This is also practised in short selling, but now the margin money gets larger than what would typically have been for general margin borrowing because the risks involved in this case are deemed greater. What is important to note here is that in short selling, a margin account is mandatory, and the investor is required to pay margin money before the actual process begins.

Under Indian laws, as long as the investor provides the margin, brokers allow the investors t+1 to t+2 settlement options. (In the investment world, 't' is the transaction date, while the numbers denote the settlement dates. So if someone says t+1, t+2 or t+3, the person is talking of the settlement dates of security transactions that occur on a transaction date plus one day, plus two days, and plus three days, respectively. The BSE and the NSE rules stipulate transactions to be completed within two trading days). If this settlement period options are not given, trading has to be completed intraday.

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Short selling risks

Short selling is out and out a speculative investment, which is what makes it risky. Why so? Because, as an investor, you can at the most only guess to what level the stock price will fall; in fact, there is no guarantee that prices will fall. If it does not, and if the price rises instead, you stand to incur losses.

Sometimes, investors short sell the same stock to protect themselves from losses if the price drops, contrary to expectations. This strategy is known as hedging. Generally, these investors are seasoned, but the strategy is very risky.

Another risk involves the margin account; here there is a potential risk of losing one’s investment as collateral. This is how this can happen: when the investor goes long on margin, the losses can be at unmanageable levels because the minimum maintenance requirement of 20-25% has to be met; if the account slips below this, the investor will be subject to a margin call and be forced to invest more or liquidate his or position.

Last word

Short selling is best left to old hands and institutional investors; if you are a fresher, avoid this route. But if you decide to get into it, it is advisable to understand all the rules. For instance, Indian bourses require you to cover your position the day you sell short. Also, naked short selling is not legal here.

Finally, do remember that while short selling multiplies your gains, it does the same for your losses too; so be prepared to take the blows on the chin. Do you think you understand the share market? Take this quiz and prove yourself.

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