What is Short Selling? – Beginner’s Guide About Short Selling

Many people think that you can earn profits in the stock market only when the prices are rising. But what if I tell you that you can earn profits even when the market is falling?

In the normal course of trading, a trader will buy the stocks first and sell later. This is known as holding a long position or simply going long. In short selling, you reverse this order. You sell stocks before buying them. This is known as holding a short position or going short.

Why will you do this? How can you sell something that you don’t own? Let’s understand this with an example.

Scene 1: The Long Position: You buy first and sell later (The usual way)

The logic is simple. Investors go long when they think the stock price of a company will go up.

Assume you buy 100 shares of Dabur India Limited at Rs. 500 per share. You expect the share price to go up. As expected, the share price rises to Rs 550. You sell your 100 shares and earn a total profit of Rs 5,000.

Scene 2: The Short Position: You sell first and buy later

A short seller makes the opposite bet. They look for stocks which are overpriced or are not doing well. They expect the stock price to fall.

In the above example, suppose you expect the stock price of Dabur India Ltd to fall from Rs 500 to Rs 450. You short sell 100 shares at Rs 500 to make money from this. As expected, the price falls to Rs. 450. You buy back your 100 shares.

Again, you make a total profit of Rs. 5,000.

Observe the order of events. You sold the shares without buying them. When the price fell, you bought back the same shares at a lower price. This is short selling. You were able to earn profits even when the share price was falling.

How can one sell something they don’t own?

You do this by borrowing the stock from your broker. To borrow the shares, you have to be approved for margin trading. It is an act of borrowing funds from a broker.

The margin acts as a security deposit with your broker as surety. You must have enough cash in your stock trading account to cover the required margin. The requirements vary among brokers. You will find all the information you need to understand various margin policies and requirements here.

Short Selling in India:

Here is a brief timeline history about short selling regulation in India –

Indian Short Selling History

Every country follows a certain set of rules authorized by their regulatory body.

In India, the Securities and Exchange Board of India (SEBI) allows traders to short sell equity only in intraday trade. So, your borrowing duration from your broker will be of one day only. If you don’t buy back the shares you have shorted before the market closes, your broker will automatically do that on your behalf. This usually happens around 3:15 PM but varies with each broker. This is known as square-off.

It can happen that shares you short might not go down as expected. Regardless, you will have to square off your position. You cannot carry forward your equity short sell position in India.

The spread of Covid-19 has shaken up financial markets. The global market crashed due to negative sentiments. Indian markets also saw a sharp fall with extreme bearishness. In an attempt to stabilize the market, SEBI imposed a ban on short-selling in March 2020. It remained in force till November 26, 2020. They also increased margin requirements to combat the panic situation.

The Indian regulator was not alone in banning short selling. Europe, China, Indonesia, and South Korea too prohibited short selling to control volatility in stocks. The ban was lifted by the end of 2020 except in South Korea. In an attempt to avoid a short squeeze, South Korea had been under the world’s longest short-selling restriction.

How to Start Trading in India?

To start trading in share market, you need to open a Demat and trading account. The broker must be a SEBI registered broker only. A Demat account holds your shares in electronic form. Whereas, a trading account helps you buy and sell shares through the stock exchanges.

Intraday trading involves buying and selling stocks within the same trading day.

Since equity short selling can only be done in intraday trading, the trader needs to select an MIS order.

Common Myths About Short Selling:

Many investors argue that short selling manipulates the market and can cause a market crash. But are these facts or myths? Does short selling really manipulate the market?

Before you start short selling it’s important to have an understanding of the share market.

Here are two common myths associated with short selling –

  1. It manipulates the market

SEBI and Indian Stock Exchanges have a strong surveillance system. In fact, the regulatory environment in India is stricter compared to other countries. They are designed by keeping traders’ and investors’ interests as a priority.

For example, lending and borrowing in stocks in India has to be done through an exchange platform. It is called Stock Lending and Borrowing Mechanism (SLBM). This platform is regulated by SEBI. It allows short sellers to borrow securities for making the delivery.

Another rule that protects the market is a SEBI regulation called Market Wide Position Limit (MWPL). This mechanism limits the net position to 20% of the free-float market capitalization of the company. Free-float is the number of outstanding shares available for trading with the general public.

There are many legal provisions that prevent traders from manipulating stock prices. Such regulations protect the integrity of the market.

If SEBI finds that an activity is executed with an intention to manipulate the stock price, such persons become liable under the law. Such regulations prevent manipulative practices in the stock market. In fact, SEBI mentions short selling as a legitimate activity and adds value in this discussion paper. It provides liquidity to the market. Most importantly, it allows people to make money in bearish markets.

  1. It is responsible for major volatility in share price

Short sellers need to borrow stocks to take short positions. In India, the regulation limits the net position to short selling. With such imposed position limits, short-sellers do not have the power to durably affect the share price. In various countries with no such limit, traders tend to find a loophole to take advantage of situations. One such recent example is the GameStop stock price. In February 2021, GameStop soared over 600% in a matter of few days, a short squeeze started by retail investors on reddit.com.

Such instances are rare in India given all the rules and regulations a trader must follow.

Watch this video to learn and understand the five-point framework for selecting stocks to short and three bear market strategies.

Importance of Stop Loss order while Short Selling:

A stop-loss order is placed to limit the losses when you fear that the prices may move against your trade. For example, if you buy a stock at Rs. 500 and you want to limit the loss at Rs. 400. You can place an order to sell the stock as soon as it reaches Rs. 400. Such an order is called a stop-loss order.

While going short, a trader wants the stock price to decrease. Hence, to protect himself from losses, he must set a buy-stop order. For example, if a trader is short selling 500 shares of Dabur India at Rs. 500 per share, he shall set a buy-stop order at Rs. 550. Once the stock hits that set price, the order executes itself and purchases the stock.

This protects the trader from incurring unlimited losses while holding a short position.

Short Selling in Future Market:

Shorting a stock in the futures segment has no restrictions like shorting in the spot market. This makes trading in futures attractive.

Suggested Read: Everything about Futures Contract in India

When you are shorting in the spot market, your selling time span is limited to one day. No matter what, you will have to close your position on the same day. Shorting a stock in the futures segment has no such restrictions.

This makes trading in futures attractive.

The big advantage of shorting in futures is that you can hedge your short position with options. When you short a stock, your call could go wrong. How can one save oneself from losses? We can hedge our position with options while shorting in future market.

For example, if you sell Yes Bank shares in futures you can hedge it by buying a higher call option. That is not possible if you are shorting in the spot market. Shorting in futures market remains a better option and is a very integral part of trading. We will learn more about the future short-selling in the following article in detail.

End Note:

Short selling involves more risk than traditional stock trading. It might sound exciting, but it’s a risky move if you are particularly new to trading. Statistics show bull markets usually stick around longer than bear markets. It provides traders with a shorter time frame to plan their short positions.

Trading takes years of discipline and practice. To become a successful trader, start learning about the markets today itself! The best way to learn something is by practically experiencing it. Take your first step towards stock market trading by opening a FREE Demat account with SAMCO.

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