What is Short Selling and How does it Work?

Short selling happens when an investor sells shares that he does not own at the time of a trade. In a short sale, a trader borrows shares from the owner with the help of a brokerage and sells it at market price with the hope that prices will fall. When prices drop, the short seller buys the shares and books a profit. To know what is short selling, it is necessary to understand that it is practised by seasoned traders and investors and is based on speculation that the price of shares will drop before they are returned to the owner. Short selling has a high risk to reward ratio as it is capable of earning profit as well as incurring huge losses.

Short Selling Factsheet

1. In short selling, the seller doesn’t own the shares he is selling. They are borrowed from another owner

2. Both retail and institutional investors are allowed to short sell

3. Short selling is based on speculation

4. The seller bets on a price drop while short selling. If the prices rise, then the seller will suffer losses

5. Traders have to honour their obligation and return the shares to the owner at the time of settlement

6. Investors have to disclose that the transaction is going to be a short sale

7. Short selling usually happens in bearish markets when the scope of price drop is high

What Is Short Selling in the Stock Market?

In the stock market, a short sale is made to earn profits in a short period. Some believe it is similar to owning stocks for a more extended period. Long-term investors buy stocks hoping for a price rise in the future, while short-sellers gauge the price situation and profit from the fall in prices.

Benefits Of Short Selling

Financial experts have often argued about the benefits of short selling. Despite controversies, market regulators across the globe have approved its practice as it helps to correct irrational overpricing of any stock, provides liquidity, prevents the sudden rise of bad stocks, and ensures promoters do not manipulate prices.

Drawbacks Of Short Selling

Market manipulators often resort to illegal use of the short-selling method to deflate the prices of stock. This increases volatility and poses a significant risk to markets that can be destabilised. The deliberate reduction in stock prices can also impact the company’s confidence and reduce its fund-raising capability.

Naked Short Selling

A naked short sale happens when the trader indulges in shorting without borrowing the stock or arranging to borrow them. When the trader does not borrow the shares before the clearing period, he is unable to tender the shares to the buyer. The trade is then considered “failed to deliver” unless the trader either closes the position or borrows the stock. Naked short selling is illegal in most countries as it defies demand and supply rules. If conducted in vast quantities, a naked short sale can destabilise the market.

What are Short Selling Metrics?

Traders use two key short-selling metrics to identify overvalued stocks or those likely to decline in value:

1. Days to Cover Ratio

• Also called the short interest-to-volume ratio, it compares the number of shorted shares to the current trading volume.
• It shows how much demand a stock has. A high ratio suggests the stock is trending bearish.

2. Short Interest Ratio

• This measures the number of shorted shares compared to the total shares available for trading in the market.
• A high ratio indicates significant short interest, signaling a likely price drop. However, it can also increase the chances of a short squeeze.

Pros and Cons of Short Selling

While short selling, a trader can face several difficulties. There may not be enough shares to buy due to the presence of many traders or shortage of stock. Some of the other disadvantages are:

1. Scope of unlimited losses

2. Cost of margin interest

3. Opportunity cost

4. Fees for stock loans

The rewards for correctly judging the price movement for short selling are manifold:

1. Low capital investment

2. Earning huge profits

3. Possibility of hedging against bear markets

4. Additional source of liquidity and revenue

Risks Of Short Selling

Apart from the risk of losing money, there are other risks of short selling.

1. Making a mistake in timing – The exercise of short selling depends on the proper timing of selling and buying of shares. Prices of the stock may not immediately decline, and while you wait to book profit, you are liable to pay margin and interest.
2. Borrowing money – Short selling means margin trading in which you borrow money from a brokerage firm using an asset as collateral. The brokerage firm makes it mandatory for you to maintain a certain percentage in the account. If you fall short of it at any point, you will be asked to meet the shortfall.
3. Choose wisely – Some companies go through bad phases but overcome them deftly. Wise administration can change the course of a company, increasing its share price instead of decreasing their value. If you choose the wrong company to bet on, you may lose in short selling when others gain by taking a long position.
4. Returning security – The seller must return the security to the owner within the stipulated period, failing which the seller will be subjected to scrutiny by the market regulator.
5. Regulations – Short selling, although permitted by market regulators, can face a ban in a particular sector any time to avoid panic. This can lead to a surge in prices.
6. Betting against the trend – Stock prices generally tend to move up in the long run. Short selling depends on prices moving down, which is going against the drift.

Conclusion

Short selling is not for inexperienced traders and speculators who are not aware of the inherent risks in the activity. Only those with in-depth knowledge of market dynamics should practice short selling.

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