Short Selling: Meaning, Benefits and Example

Short selling is a trading strategy that allows investors to profit when the price of a stock or asset falls. While regular buying involves purchasing a stock hoping its price will rise, short selling does the opposite. It’s often used by traders who believe a stock is overvalued or about to decline.

In this blog, we'll explain how short selling works, the metrics used to analyse it, along with its benefits, risks, and a simple example.

What is Short Selling?

Short selling is the act of selling a security that you do not currently own. Traders borrow the stock from a broker and sell it in the open market, hoping to buy it back later at a lower price. If the price falls as expected, the trader profits from the difference.

This strategy is often used to speculate on a price decline or to hedge against other investments in the portfolio.

How Short Selling Works?

The process of short selling follows these basic steps:

1. Borrow the Stock: The trader borrows shares from a broker.

2. Sell in the Market: The borrowed shares are sold at the current market price.

3. Wait for the Price to Drop: The trader watches the market, hoping the price will fall.

4. Buy Back at a Lower Price: Once the price drops, the trader buys the same number of shares at the new lower price.

5. Return the Shares: The trader returns the shares to the broker and keeps the difference as profit.

Example:

Suppose a trader believes that shares of Company A, currently priced at ₹500, will decline. They borrow 100 shares and sell them, earning ₹50,000. If the price drops to ₹450, they buy back 100 shares for ₹45,000. The profit is ₹5,000, excluding fees and taxes.

What are Short Selling Metrics

Several indicators are used to assess short selling activity and potential risks:

• Short Interest: The total number of shares sold short but not yet covered. High short interest may indicate strong bearish sentiment.

• Short Interest Ratio (Days to Cover): This is calculated by dividing the short interest by the average daily trading volume. A higher ratio means it may take longer to cover all short positions.

• Put/Call Ratio: Though related to options, a high put-to-call ratio can support bearish sentiment in the market.

• Cost to Borrow: The fee charged to borrow the shares. It can increase when many traders are shorting the same stock.

Benefits of Short Selling

Short selling offers unique advantages when used wisely:

• Profit from Price Drops: Traders can make gains even when the market or a particular stock is falling.

• Hedging Tool: It can be used to balance the risk of a long position in another asset.

• Market Efficiency: Short sellers often identify overvalued stocks and bring more accurate pricing to the market.

• Liquidity: Short selling adds liquidity to the market, which helps with smoother trade execution.

Example of Short Selling

Let’s consider another basic scenario:

Ravi believes shares of XYZ Ltd, currently trading at ₹300, are due for a fall. He borrows 200 shares and sells them for ₹60,000. A week later, the stock drops to ₹250. Ravi buys back 200 shares for ₹50,000 and returns them to the broker. His profit, before expenses, is ₹10,000.

This example shows how short selling can be profitable when a trader correctly predicts a price fall.

Advantages of Short Selling

• Flexible Strategy: Can be used in both rising and falling markets depending on other positions held.

• Potential for Quick Returns: In volatile markets, price declines can happen quickly, leading to fast gains.

• Helps in Risk Management: Especially when used alongside long positions.

• Exposes Overvalued Stocks: Short sellers often perform deep analysis, helping reveal weak companies or inflated valuations.

Disadvantages of Short Selling

Despite its advantages, short selling comes with several risks:

• Unlimited Loss Potential: If the stock price rises instead of falling, losses can be unlimited since there’s no upper limit to a stock’s price.

• Margin Requirements: Brokers usually require a margin account to short sell. If the price moves against you, you may need to deposit more funds.

• Short Squeeze: When a heavily shorted stock suddenly rises, short sellers rush to cover their positions, pushing the price even higher.

• Timing Risk: The market may take longer than expected to correct itself, tying up capital or causing losses.

• Borrowing Costs: Some stocks are expensive to borrow, which adds to the cost of the trade.

Conclusion

Short selling is a useful tool for experienced traders who can manage risk effectively. It allows profit opportunities in declining markets and can also serve as a hedge. However, the risks involved are high, especially in volatile conditions. It’s important to understand the mechanics, monitor the relevant metrics, and have a solid strategy in place.

For most retail investors, short selling should be approached with caution and preferably under the guidance of a qualified advisor.