Short Selling: Meaning, Pros and Cons

What Is Short Selling?

In the previous chapter, we learned about secondary market transactions, which are crucial for navigating the stock market's buying and selling dynamics. Now, let’s dive into the world of short selling, where we explore flipping the traditional buy-low-sell-high strategy on its head.

When we think about making a profit on a transaction, traditionally, our mind is trained to think of buying something at a lower price and selling it later at a higher price. The difference between the two prices is our profit on the transaction. 

Short selling, also known as ‘shorting’, works exactly opposite to the idea of buying and selling. In short selling, you sell the underlying asset first and then buy it later to complete a transaction. The difference between the selling and buying prices is the resulting profit or loss from the transaction. It is a simple method of trading in financial instruments/assets with a slight catch, i.e., instead of buying the asset first, you simply borrow the asset from someone who already owns it. 

Once you have the borrowed asset, you can sell it in the market, later buy it, and give it back to whom you borrowed it from. This act of buying the asset and returning it back to the lender is known as squaring off your position. 

Short selling is a trading strategy that is ideally used in a bearish market, as profits in a short sale are made only in case of a decline or fall in the underlying asset's price. In the case of short selling, the buyer of the underlying asset is said to be taking a long position on the asset, and the seller is said to be taking a short position.

Let’s understand this through an example. Let’s say you have ₹1,00,000 as capital. You have been analysing the stock chart of XYZ Limited. Based on your analysis, you strongly believe that the stock price of XYZ Limited will decline in the near future. You decide to take a short position on the stock. With your capital, you borrow 1,000 stocks of XYZ Limited from a broker and sell them at the market price of ₹100 per stock. 

After 2 weeks, the stock price of XYZ Limited fell by 20% and dropped to ₹80 per stock, as you had predicted. At this point, you can buy 1,000 stocks you had previously sold and return them to the broker from whom you borrowed them. Considering the difference of ₹20 between the selling and buying prices, you will profit from ₹20,000 on this trade.

The example that we discussed above may look like it involves complex transactions with multiple steps. However, in real-time trading, all of these steps take place in a matter of seconds. 

Hopefully, you have understood short selling or shorting at a conceptual level now. Let’s delve a little deeper into the other aspects of short selling.

Why Sell Short?

The answer to why a short sell takes place or is undertaken lies in the trader's intent behind taking short positions in the market. The trader may intend to hedge to protect their existing investment where they have taken a long position or may be interested in taking advantage of price differences across the trading platform, or they may simply intend to make profits by speculating in favour of the downward movement of the market or the concerned asset. 

Let’s understand each of the above scenarios by way of an example. 

Scenario 1: Let’s say you hold certain shares of PQR Limited, which you had purchased from a considerably long-term standpoint. However, due to broader market momentum, you predict that the share price of PQR Limited may decline. Here, although you wish to continue to hold your long position in the market, you also want to stay protected from the fall in your share price. Thus, to secure your primary investment, you may execute a short sale transaction so that you can set off your losses on the primary investment against the profits made on the short sale transaction when the share price of PQR Limited falls.

Scenario 2: In the second scenario, let’s say the shares of PQR Limited are trading on ‘Stock Exchange A’ at a price per share of ₹100. However, you find out that the price of these shares on ‘Stock Exchange B’ is ₹99 per share. You may sell the shares on Stock Exchange A at a price of ₹99 and buy the shares from Stock Exchange B at ₹100 per share. This way, you will make a profit of ₹1 per share on your trade. This is called arbitrage in market parlance. 

Scenario 3: In the third scenario, you may bet on your prediction that the price of PQR Limited will decline. Thus, you execute a short sale transaction where you sell at a higher price and later buy the shares at a lower price, thereby making a profit.

Pros and Cons of Short Selling

Pros of Short Selling

1. Advantageous in Bear Market: Through short selling, you can make profits even in bearish markets by taking advantage of declining prices. This provides traders with an additional source of liquidity and profit making.
2. Hedging against risk: As we discussed in one of our previous examples, short selling helps traders to protect their primary investment from any expected fall in the market.
3. Low capital investment: Since short selling takes place on a margin basis, i.e., you are only required to deposit a portion of your total trade value with the broker, it allows you to trade in high-value positions with a relatively small capital investment, and thereby also opening the possibility of making high profits with that capital.
4. Portfolio diversification: Diversification is not only limited to parking your capital in different types of assets and securities. It also extends to taking different positions in the market, which means it also includes taking both long and short positions in the market. This allows investors to adjust risk and manage overall portfolio volatility.

Cons of Short Selling

1. Possibility of uncapped losses: Traders who indulge in short selling are exposed to the risk of uncapped losses, which may be experienced from a rise in the asset price. After a short position has been executed, traders start experiencing a rise in loss as the price of the stock rises. When you enter into a transaction with a long position, the maximum risk you carry is the value of your stock becoming zero. On the other hand, in the case of short selling, the maximum risk is unlimited since there is no limit to how much the price of a stock can increase. 
2. Maintenance of margin: Since short selling requires a deposit of a certain margin with the broker, you may be required to deposit additional margin if the amount of loss incurred on your trade results in the margin amount falling below the minimum margin required to be maintained.
3. Short squeeze: In cases where the asset price shoots up or starts rising substantially, all short sellers start to settle their positions in the market by placing buying orders to limit their losses. The sudden increase in buying orders in the market may lead to a further increase in the asset's price, thereby resulting in a short squeeze.

Is Short Selling Ethical?

Short selling is looked upon in bad light because short sellers expect the price of the stocks to fall. These sellers put their money into stocks, hoping the company's value will drop. This can lead to doubts about the company's future. It can also affect others connected to the company, like employees, creditors, and consumers. 

The other side of the argument is that short sellers help in keeping a check on the inflating prices of stocks resulting from a raging bull run. It is argued that this helps prevent a sudden market crash; stock prices are continually being corrected through short selling. These regular corrections in the market improve market efficiency due to the prevalence of fair prices resulting from this price discovery phenomenon facilitated by short selling.

Considering the checks and balances that short selling offers to the market, it becomes difficult to argue whether short selling is really unethical. However, the market has in the past witnessed instances of unethical conduct where short sellers have attempted to spread cooked-up information in the market to influence the stock prices to move in the desired direction. However, such unethical conduct cannot be taken to mean that short selling is unethical in principle.

Conclusively, there is no right or wrong here.  But it is better to know both sides of the story to understand the practical aspect of short selling better.

Short-Selling In India

You are now aware of the risks associated with this type of trading. Did you know that short selling was permitted in India but banned from 2001 to 2008? A scam rocked the markets where certain personnel at the Exchange allegedly used insider information (confidential information about a company) to make profits from short-selling stocks that led to a decline in stock prices across the board! SEBI absolved the parties of any wrongdoing later, but the damage was already done.

March 2020 to October 2020 also saw a temporary ban on short selling on account of the pandemic-led economic turmoil. 

In its true sense, short selling is not practised in India yet. We do have intra-day trading and futures trading that are often confused with our concept in focus because short-selling strategies are similar to the strategy used in all of these.

Bottom Line

In this chapter, we explored the concept of short selling. We discussed why people do it, like to protect themselves from losses or to make quick profits. We also touched on the ethics of short selling, as some people think it's unfair while others see it as a way to keep markets in check. Short selling is part of how the stock market works, adding complexity and opportunity for those who understand it.

With this exploration, we conclude our module on "How does the stock market work?", shedding light on a strategy that adds depth and dimension to the ever-evolving domain of financial markets.