Updated Feb 09, 2022

What is short-selling?

What is short-selling?

The standard, most common method of earning money in the stock market is this: buying shares at a lower price and selling them at a higher price. Most people require years of study to gain expertise in this standard method. They think that one can only profit in the share market when the prices continuously increase, but it is a misconception. However, there is a way to earn money even while the market experiences downfall in prices.

People follow two trading courses in the stock market - the long and the short positions.

• Long position - People buy stocks first and then sell them at a high price.
• Short position - People sell the stocks first and buy them at a low price.

This article will tell you all about trading in the short position.

How does short-selling work?

Holding the short position is also called short-selling. Traders look for overpriced shares that are not performing well in the stock market. If they expect the value of these shares to fall on the same day, they sell them. When the price decreases, they buy the shares they had previously sold. The difference between the selling and the buying price is their profit.

Here is an example of short-selling: Assume your friend/broker has 1KG of GOLD. You approach him asking to borrow it for a day. You promise to return it before 3:30 PM or before the market close.

You sold the newly-acquired GOLD in the market for a specific price (assume "50,000") to somebody. After some time, you found that GOLD prices had dropped.  You purchased the same GOLD you had sold at the lower price (assume "48000"). You return the GOLD to your friend.

In this process, you sold the GOLD first at a higher price and purchased it at a lower price. Your profit is the difference between the selling price of the GOLD the cost price at which you bought again ( A-B)

Disclaimer- Had the GOLD prices increased after you sold it, you have to book some losses. You would be bound to buy it at a higher price than you sold to return it to your friend before 3:30 PM or before the expiry of your contract.

How does one sell the shares before buying them?

Everyone is not cut out for short-selling because only a few people who meet the criteria for margin trading can sell stocks without purchasing them. They short-sell by borrowing the shares from their broker after fulfilling the requirements. To get approved for margin training, you will need to have a certain amount of cash in your stock trading account.

Why do traders need a stop-loss order while short selling?

While short-selling traders want the prices of the shares to fall, however, these prices can move against the expected direction, making short-selling a risky game. This is where the stop-loss order comes into play. For instance, suppose you buy some shares of rupees 100 each and want to cut your losses at rupees 50, then you can place a stop-loss order to sell the shares as soon as the price reaches rupees 50.

Short-selling in the future v.s spot market: which is better?

In the spot market, you have to sell and buy your share within the same day. If the stock price does not fall the same day, you incur a loss. After all, you will still have to buy it even if the price does not decrease.

Trading in the future market extends beyond one day, thus buying you enough time. You also hedge options while trading in the futures market. Your pay off after buying in the future market will be similar to that of the spot market.

Most people consider trading in the future market a better option than in the spot market.

Pros of short-selling

• Short-selling improves liquidity because it regulates overpriced shares.
• It allows people to earn money and stay engaged in the stock market even when the prices are falling.
• Short-selling requires less money than traditional trading practices.

Cons of short-selling

• Short-selling is risky because prices can increase before the trader purchases the shares.
• It is difficult to borrow a stock when available shares in the market are limited or less in number.
• Less liquid stocks are expensive, and the regulating bodies can ban short-selling during volatile marketing conditions.

What is the status of short-selling in India?

Every country has rules and regulations related to short-selling. Indian traders can short-sell only intraday, according to the Securities and Exchange Board of India (SEBI). After the spread of the Covid-19 pandemic, the Indian stock market experienced a sharp fall, due to which the government banned short-selling in March 2020. The government lifted the ban after November 26, 2020. However, they increased the margin requirements to deal with the delicate situation.

How to be good at short-selling?

One with sound knowledge of the financial market can engage in short-selling. One should understand market dynamics like direction, liquidity, volatility, and volume before trying their hand at short-selling. Understanding technical analysis is an added advantage if you want to short-sell stocks. Thus, short-selling is not a game for novice traders as it involves considerable risks.

Conclusion

Short selling in the share market is risky due to the limited time frame. It sounds exciting but can be difficult for people new to stock trading. Earning money in the stock market requires years of study, guidance, practice, and experience, without which it is a risky space to engage with.