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An introduction to Short Selling

These days, you would have heard a lot about short selling or short sales or going short. Whether it is banning of short selling around the world, or allowing short selling in India, short sales have definitely been in news lately. Time to find out more about it!



In the normal course of trading or investment, you buy shares. When the price goes up, you sell the shares and make a profit. Its simple: Buy low and sell high. Right?

We all know what selling is. But what is short selling? Let’s find out!

What is Short Selling?

Normally, when you think the price of a stock is going to increase, you buy the shares. You wait for the price to go up, and sell them at a higher price, thus making a profit.

What if you think that the price of a stock is going to go down? Well, if you own these shares, you sell them so that you can prevent a loss.

But is there any way you can make a profit if you think that the price of a company’s share is going to go down?

Yes – and that’s where short selling comes in. The basic definition of short selling is:

Short selling is selling the shares that you do not own.

Sounds difficult to understand? Let’s explore.


How does short selling work?

During normal investment, you start with 0 shares. You buy some shares, say 100. So, you have a +100 position.

Then, you sell these shares at a higher price. Your position is:

+100 –100 = 0.

During short selling, the logic is to sell the stock, and buy it back later. This is also called going short.

Again, you start with 0 shares. You sell some shares, say 100. So, you have a -100 position.

Then, you buy these shares back from the market at a lower price. Your position is:

-100 +100 = 0.

So, it’s just like a regular buy-sell trade!

Let’s go through an example so that the concept gets clearer.

Example

Normal Investment

You buy a stock for Rs. 100, assuming that its price would go up. Its price does go up, and you sell it at Rs. 125.

Profit = Sale price – Purchase price = Rs. 125 – Rs. 100 = Rs. 25.

When you short sell, you sell a share thinking that the price of a share would go down.

Thus, you sell the share at Rs. 100. The price of the share goes down to Rs. 90, and you buy it back.

Again,

Profit = Sale price – Purchase price = Rs. 100 – Rs. 90 = Rs. 10.


But, how is this possible?

You must be wondering – “How can I sell something that I do not own?”

Also, what happens to the buyer to whom I short sell? How does he get the delivery of these shares?

There is a mechanism to take care of this – it is called Securities Lending.

The short seller sells the shares that he doesn’t own. Then, he borrows these shares from a lender, and delivers it to the buyer. The short seller pays a fee to the lender for this- just like interest is paid for borrowing money.

At a later stage, the short seller buys the shares from the market, and returns them to the lender.

Day Trading and Short Selling

Short selling can also happen in day trading – but in that case, the short seller squares-off the position on the same day before the close of the market.

That is, the short seller buys the shares from the market on the same day. His net position is zero, and during settlement, there is no net delivery position. Thus, the question of borrowing the shares doesn’t arise.

Here, we are talking about a genuine negative view about a stock – where a person thinks that the price of the share would go down over a few days, and not just intra day.

Thus, the short seller sells the stock, and he borrows it so that he can deliver it during the settlement. Later, he buys it from the market, and returns to the lender.

The short seller can keep this short position open for a number of days – unlike an intra-day short sell, where the position is squared-off on the same day.

Advantages of Short Selling

The main advantage of short selling is that it provides liquidity in the market.

Short sellers become counter-parties to regular investors, many times during bear markets, thus providing liquidity.

Participation of short sellers also increases the number of participants in the market, and the number of trades. This helps in better price discovery.


Disadvantages of Short Selling

The main disadvantage of short selling is that it can have a destabilizing effect on the price of the stock – and on the equity market in general – if it is a synchronized effort by many market players.

If many short sellers team up, and undertake short selling simultaneously (also known as hammering the stock or hammering the market), it can result in the price of a share / market index crashing.

Short Selling in India

Short selling was highly prevalent in India in the 1990s. In 2001, it was banned after the Ketan Parekh stock market scam.

In December 2007, the Securities and Exchange Board of India (SEBI) reintroduced short selling in the Indian market. From February 2008, even institutional investors – including Foreign Institutional Investors (FIIs) – were allowed to undertake short selling.

Naked short selling is not allowed in India – that is, you have to borrow the stock for delivery during settlement if you short sell.

Securities Lending and Borrowing (SLB)

SEBI has introduced a mechanism of Securities Lending and Borrowing (SLB) in India to facilitate short selling.

As we have seen, naked short selling is not allowed – you have to borrow the shares for delivery. The Securities Lending and Borrowing (SLB) framework makes this process smoother.

Through this mechanism, investors – both retail and institutional – can lend their stocks to short sellers and earn a fee for this service.

This means that long term market players like mutual funds (MFs) and insurance companies that hold their stocks for prolonged periods can now lend these shares, and earn an extra income out of it – just like you earn an interest for lending your surplus money to the bank!

Currently, there is not much volume through the SLB mechanism, and therefore, the liquidity is low. But it is expected to pick up in the future, benefiting long-term investors.

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