Introduction

Ever heard of earning profits when the market falls? Well, this obviously sounds weird as to how can someone earn profits if the prices are falling! Short sellers do the same. Traditionally, to earn profit, investors used to buy at lower price and then sell at high price. However, short selling allows the investor to sell first at time, when the market is trading at high. The short seller square off his position by buying the stock later on. The gross profit or loss depends on the buy price of the short seller. So, essentially short selling moves down the stock prices from a higher level. However, in India, as per SEBI rules, short selling is available for intraday only.

Contents of this article

  • Short Selling: Definition and meaning
  • How does short selling work?
  • Importance of Short Selling
  • Short Selling in Stock Market
  • Impact of Covid-19 on Short Selling
  • High Risk Potential
  • Advantages of Short selling
  • Disadvantages of Short selling
  • Application of Short selling
  • Wrapping Up
  • References

Short Selling: Definition and Meaning

Short selling is a trading methodology used by portfolio managers for the purpose of speculation or hedging against the downside risk for any stock and gaining from such decline in the stock prices.

Thus, it basically means selling a security (for example, share or debt instrument of a company) without owning the same. Sounds little weird, right? How can a person sell something which he does not own!

This can be done by “borrowing the security from another person and then selling in the market”. So, there are three parties involved in the trade namely,

  1. Short seller
  2. Security buyer
  3. Lender of the security.

The sale consideration has been received by the short seller. What about the lender? Won’t he ask for the security back? Normally, the lender does not ask for the security immediately. The lender provides the security for a specified period only. The lender will charge stock lending charges for such period.

During the intermediate period, the short seller has to purchase the security from the market and return it back to the lender.

The profit of the short seller depends on the difference between the sale price and purchase price of the security. In case, the short seller gets the security at a higher price, he has to book a loss.

However, the major drawback of short selling is that the short seller has to square off of his position before stock closing, i.e. on same day. Or we can say, In India, short selling is available on intraday basis only.

How Does Short Selling Work?

Lets’understand the Short Sell mechanism with the help of example and consider the following data to understand the process-flow of “Long” v/s “Short Sell”

As an example, we can consider the stock of IRCTC which is currently trading at say ₹ 1450.

Scenario 1: “Going Long”

Step 1: The investor will purchase the stock at ₹ 1450
Step 2: Say the stock appreciates to ₹ 1650 till market closing time and the investor sells the same.
Step 3: Here, the investor has made a profit of ₹ 200 per stock (ignoring the transaction charges). Also, the said profit is taxable at the rate of 15% as short-term capital gain as per section 111A of the Income Tax Act, 1961.

Scenario 2: “Going Short”

Step 1: The short seller will borrow the stock through the stock broker for a certain period.
Step 2: The short seller will sell the stock at ₹ 1450 at the present price with the belief that the market will crumble down and the stock will be available at much lower price.
Step 3: After a couple of days , At the time of market closing, the stock is available at ₹ 1300 and the short seller purchases the same. He, then returns the same to the stock broker.
Step 4: He has made profit of ₹ 150 per stock (ignoring the transaction costs). Also, the said profit is taxable at the rate of 15%.

short selling going

Importance of Short Selling

There are buyers as well as sellers in the stock market, without whom the market cannot work. For the smooth functioning of the market, it needs both i.e., people on the long side (buyers) and people on the short side (sellers).

The prices move up if there are many buyers in the market i.e., the demand for the stock is so high that buyers are ready to pay higher price. Conversely, the prices fall when there are huge number of sellers and lower number of buyerssellers want to sell the stock as soon as possible. This pushes down the price. Thus, short selling pushes down the stock price.

One needs to understand that, the stock market is generally treated as proxy of the economic growth. Rise in the stock market, presents investments by the traders and public. Also, fall in the market represents, people want liquidity and thus, they square off their holdings. Stock market is generally gives an advance signal of economic growth. A classic example can be witnessed during the Pre-COVID-19 scenario

short selling graph

The market started to collapse in the first week of March 2020 when the Covid cases were amplifying its base in India. Also, other developed countries over the world were experiencing lock down already in 1st week of March resulting in falling of the global indices. The short sellersneed a single reason for shorting the market and here, they had global cause affecting the world economy. However, the downfall continued until the end week of March, wherein India had gone under complete lock down. You can see a slow and steady increase thereafter. This was the sign of easy and early recovery of Indian economy after the downfall caused due to the pandemic. The actual economy steadiness was observed after August 2020.

The collective action of the short sellers has a significant impact on the overall market. High growth entities blame the short sellersfor the decline in the stock prices. Thus, there are many instances wherein the short selling has been banned.

However, every trade has some risks. Firstly, there is unlimited loss potential in case the stock rises sharping instead of falling.

Secondly, the general tendency of the public in India is investment which leads to rise in the market.

Thirdly, short covering can lead to further risk in the prices. Short covering refer to buying the stock now which the investor had short sold earlier.

Why Is Short Selling Notorious?

Short selling is based on the belief that the stock prices will decline in the near future. The short seller borrows the security from a stock lender, sales the same immediately at the available higher price and purchases the same before market close, at lower price. This enables the short seller to gain from the difference of higher sell price and lower purchase price.

This is exact opposite style of investment from traditional methods,as the gain is dependent on fall in stock prices.

However, it is believed that a major sell off has impact on declining the market and it causes recession in the country. Markets are proxies of the economic growth supported by the buy-side belief of normal investors.

Also, it can be argued that short selling will leads to artificial dampening of the stock prices of those companies which are fundamentally strong. No company favor the reduction of its stock price and thus, few companies insists on a ban on short selling.

Short Selling in Stock Market

Now, let’s come to the practical front of the stock market. The short-selling in the stock market can be discussed in two practical aspects as follows:

Aspect 1: Spot Market Short selling

Spot market means the present market in which investors normally trade-in. Here, the trader identifies the expected downfall of the stock price using various methods such as holding a volume of traders, the above-average volume of the stock movements, the resistance and support level, and other downside indicators Thus, the trader uses the technical analysis to identify the expected decline. In the trading software, you can simply sell the stock directly, which will create a short position for yourself. The stock can be sold by entering the details such as quantity, price, and stop loss. Stop loss means something which helps you to stop the loss. You will experience loss if the stock price is climbing instead of falling. Stop-loss helps you to close off the trade to avoid the loss beyond the acceptable level of the investor.

Let’s take the following example to help you understand the process:

Stock Name SBI Cards
Current Market Price ₹ 1,015
Expected Downfall ₹ 964
Number of stocks 1,000
Sell at ₹ 1,015
Buy at say ₹ 970
Profit per stock ₹ 45
Gross Profit ₹ 45,000
Transaction charges say 0.1% of turnover ₹ 1,015
Net Profit (45,000-1,015) ₹ 43,985

Let’s see the movement in next 10 days:

Day Nifty Value for reference Closing Value Movement P&L for the day Profit/ (Loss) Deposit Amount
1 ₹ 15,183 ₹ 15,103 ₹ 80 ₹ 8,000 ₹ 2,58,000
2 ₹ 15,103 ₹ 14,751 ₹ 352 ₹ 35,200 ₹ 2,93,200
3 ₹ 14,751 ₹ 14,566 ₹ 185 ₹ 18,500 ₹ 3,11,700
4 ₹ 14,566 ₹ 14,370 ₹ 196 ₹ 19,600 ₹ 3,31,300
5 ₹ 14,370 ₹ 14,570 (₹ 200) (₹ 20,000) ₹ 3,11,300
6 ₹ 14,570 ₹ 14,721 (₹ 151) (₹ 15,100) ₹ 2,96,200
7 ₹ 14,721 ₹ 14,801 (₹ 80) (₹ 8,000) ₹ 2,88,200
8 ₹ 14,801 ₹ 14,686 ₹ 115 ₹ 11,500 ₹ 2,99,700
9 ₹ 14,686 ₹ 14,436 ₹ 250 ₹ 25,000 ₹ 3,24,700
10 ₹ 14,436 ₹ 14,386 ₹ 50 ₹ 5,000 ₹ 3,29,700


Explanation:

As you can observe, there is huge volatility in the daily returns since the futures have huge volumes than the spot market. Huge volatility means higher chances of positive as well as negative returns one after another day. So, in the case of volatility, there is no consistent gain or loss.

Thus, futures will always amplify your returns. In the above example, at the end of day 10, ₹ 2,50,000 invested earlier has become ₹ 3,29,700 i.e., differential gain of ₹ 79,700 (32% of ₹ 2,50,000).

Now again, “Is it that simple & possible?” Yes, but subjective to the fact that markets can never be timed so accurately. It may happen that the prices move unintentionally in an uptrend for a longer period in which case the margin money may vanish just in few days.

Impact of Covid-19 on Short Selling

Since January 2020, the world has witnessed the global pandemic COVID-19. The virus behaved like a “pausebutton” on the global movement of everything. The entire human life was paused. Many companies opted to close the business due to probable losses expected from the global pandemic.

Many countries around the globe had to suffer from the “Lockdown-phase” for months together. However, it was observed that the market in India started to crash a month before the lockdown was imposed due to the negative sentiments prevailing in the country. This is the reason why markets are said to give “advance signals of economic wellbeing”.

Short sellers played a significant role in such a global sell-off, leading to a sharp decline in the market. During the short span of February 2020 to March 2020, nearly 40% of the investor’s wealth was destroyed by the sell-off.

When the investor’s money is at risk, the market regulator SEBI (Securities Exchange Board of India) will take immediate actions to ensure a smooth flow of markets. Considering the huge downfall in a short span of 20 days in March 2020, SEBI halved (i.e., 50%) the position limits for certain stock futures, high restrictions for short-selling of index derivatives, and raised margins for few shares. Everything was done to curb the “abnormally high” volatility caused by the fear around the globe.

SEBI also restricted the amount of short-selling for index derivatives by mutual funds, FPIs, and even for proprietary traders. These directions continued for approx. 1 month.

High-Risk Potential

When a stock at ₹ 950, what is the maximum amount you can lose? That’sa ₹ 950 loss only. However, there is an extremely rare chance of a stock price falling to zero. Imagine a case, where you had short-sold the stock at ₹ 980, what is the maximum amount you can lose? Infinite. Yes, there is no upper band (theoretically).You can limit your losses by specifying the stop loss.

This situation of no upper band is the biggest risk faced by short-sellers. Does this mean that the market in the long term is made for upside-only? Technically, the answer is “yes”. Traditionally, investors in India have a biased expectation of up move only. This expectation is reflected in the BSE Sensex value rising from ₹ 15,000 in the year 2010 to ₹ 28,000 by the year 2015 and to ₹ 50,000 in January 2021.

Does this mean that there is no use of short selling? Short selling is helpful for the market to cool down. The prices move up with a huge number of buyers, However, the prices cannot up beyond a certain in case the fundamentals of the Company and there is mere speculation for up-move. In a short period, short sellers will help to reduce the prices near to their fair value. Thus, Short selling is equally important for the market to stay at reasonable levels.

Short sellers can book their profits in the interim periods of downfall.

Advantages of Short Selling

There is no or minimal investment and thus, short selling is earning without owning the stock. The broker demands a margin that can be managed.

Only stock lending charges are payable by the short seller, which are rental charges onthe lower side.

You can easily trade in the market by open any trading with a broker, who can arrange the lenders for the stock.

Markets are very sensitive to bad news. It can be crumbled like anything in short term. This is where the short sellers can easily book the profits.

The returns can be amplified due to the involvement of margins.

Disadvantages of Short Selling

Short selling is possible only for the short term. You cannot hold a short position for life long and expect the liquidity news of the Company. SEBI has allowed only a shorter period of trade in short selling, i.e. Only intraday.

At maturity, you have to return the stock to the broker. This is automatically done by the broker at the maturity at the available market price. In case the price stays at the upside, you will have to suffer loss.

The short seller may face a situation of “short squeeze” wherein the lender demands the stock before the maturity date. This is one of the biggest risks of short selling since you will have to return the stock at the current prices immediately.

The traditional market in India is an upside market and thus, there is a low chance of stock prices falling below the fundamental prices. Upside has no limit and similarly, there is no limit for maximum possible losses of the short seller. He can do so only by entering the stop loss.

Application of Short Selling

Suppose you buy varied types of stocks with an investment of around ₹ 1 crore. You may suffer losses in case the market declines and your portfolio react similarly to market movements.

In such a case, short selling works as a hedging tool to ensure that the loss in the portfolio made due to decline can be compensated by the short-selling mechanism.

The primary objective of hedge is to protect the investors from incurring losses. Short selling is best suited for institutional traders (Corporate investment entities) holding crores of the portfolio in different segments of the market.

Wrapping Up

Short selling can be termed as very risky trading and mostly done by speculators only. Before taking a short position, the short seller must understand the market and its mechanism properly or it will lead to heavy loss, as said above, the amount of loss in short selling is unlimited.