Investment word of the day: What is short selling in stock market and how does it work? Risks and rewards explained | Stock Market News

Short selling is a trading strategy where an investor borrows some stocks from a broker, betting that the price of the stock is going to decline in future, sells them at the current market value and buys them again at a lower price to make a profit. So, short sellers borrow shares from a broker, sell them, wait for a price drop, buy the same number of shares back when the price drops, return the shares to the broker and earn the profit. Let’s look at it one by one.

How does short selling work in stock market?

1. A trader borrows some shares of a stock from a broker/brokerage.

2. The trader sells the borrowed shares at the prevailing market price after buying.

3. The trader waits for the price of the stock to drop keeping an eye on the market trends.

4. The trader then buys the same number of shares he had sold earlier at a lower price.

5. The borrowed shares are returned to the broker, and the trader pockets the difference as profit.

Example of short selling in simpler terms: Sanchari borrows 10 apples from Mausam having a market value of ₹10 apiece. That makes them worth ₹100.

She then immediately sells those 10 apples to Pratik and buys them back when the price of the apples drops to ₹5 per piece – for ₹50.

Sanchari then returns them back to Mausam and makes ₹50 as profit.

That’s how short selling works in the stock market.

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Risks in short selling

Short selling has the potential for both unlimited losses and significant gains. If the stock price rises instead of falling, losses can be limitless. However, if the stock price drops as expected, the profits can be substantial.

The short selling also comes with the brokers’ demand to maintain a certain account balance. If the stock price rises and the traders have to buy them back, the brokers may demand the traders for more funds to cover their losses.

Timing is also a huge factor to consider in short selling. The decline in the stock prices, even if rightly anticipated, may take longer than expected. This can result in extended costs in terms of interest to be paid on borrowed stocks.

Short Selling: The process explained

To understand the process of short selling, one will need to understand what a margin account and margin trading is.

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Margin account: A margin account is an account one opens with a broker which allows you to borrow money or securities from your broker. Margin trading is a strategy where an investor borrows money from a broker to buy or sell securities.

You use that money or securities to trade for short selling.

Margin account requires a minimum balance called the maintenance margin. This is used when the broker wants to recover losses.

As per SEBI, “The initial and maintenance margin for the client shall be a minimum of 50 per cent and 40 per cent respectively, to be paid in cash.”

Example: 1. You, as a client, identify a stock and want to buy some for ₹10,000.

2. If the initial margin is 50 per cent, you must deposit ₹5,000 in your margin account.

3. And the broker lends you the remaining ₹5,000 to complete the purchase.

4. After buying, you must always maintain a minimum balance in your account.

Here’s how to open a margin account:

1. Select a brokerage that offers short selling. Do make sure it has a good reputation.

2. Fill out the forms/application process (if any)

3. Submit your papers and personal details

4. Deposit the maintenance margin and begin the process.

Note: Make sure you understand the margin calls before you place your bets

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How to short-sell: Step-by-step process

1. Identify a stock that you believe is overvalued and have enough evidence – market sentiments, quarterly results, financial reports and other details – to determine that the stock price will fall in the near future.

2. Place the order to short the stock after checking if they are available with the broker.

3. Wait for the stock price to drop. If the price falls as expected, you can buy it back at a lower price to make a profit.

4. The trader then can pocket the difference as profit and return the shares to the broker.

5. If the stock price increased instead of dropping, the trader will have to buy them back at a higher price to complete the short selling circle, resulting in a loss.

Example in simple terms: 1. You, as a trader, short 100 shares of ‘Chauhan Limited’ company. Each share is priced at ₹50.

2. Total sale value is at 100 * 50 = ₹5,000

3. You place your order to short the stock and wait for some days for the stock price of ₹50 per share to fall.

4. Say a week later, the stock price of ‘Chauhan Limited’ is ₹40.

5. Taking this opportunity, you buy back all the 100 shares for ₹4,000 (100 * 40 = ₹4,000)

6. You return 100 shares to the broker and pocket the profit ( ₹5,000 – ₹4,000 = ₹1,000)

7. Your profit was ₹1,000.