What is Short Selling?

There are several trading strategies that seasoned market investors follow to maximise their gains. Short selling is one such strategy which involves speculation and profiting from the decline in prices of a stock. It is effective in bearish markets where share prices are anticipated to decrease. 

What is Short Selling

Short selling, as opposed to a long position, is an investment strategy with the underlying motive of "buying low and selling high." Investors who short-sell stocks expect share prices to drop in the future and aim to capitalise on this prediction.

How Short Selling Works

Short selling in the stock market depends on speculation and entails infinite risk theoretically. Usually, seasoned investors partake in short selling. 

Here are some aspects of the process: 

• To short stocks, traders sell shares that they do not own, but are instead borrowed from a broker-dealer. Thereby, they open a position. 
• Traders sell them at the prevailing market rates, thereby shorting the position and waiting for the prices to fall. 
• Eventually, they need to buy back the stocks sold short to close the position. 
• If prices do fall, traders earn a profit from the difference between the selling price and the purchasing price. Yet, if it does not happen and share prices move upwards instead, then they stand to lose money. 
• Fund managers and investors use short selling to hedge against the downside risks of holding long positions on securities or related assets. 
• Traders need to have a margin account to sell short, using it to borrow stocks from a broker-dealer. They have to maintain the margin amount in the account to continue holding a short position. 

Thus, a margin account is essential when you are borrowing shares from a broker.

What are Short Selling Metrics

Traders primarily resort to two short-selling metrics to determine which stocks are overvalued or are expected to fall in value in the future. These are –

Days to Cover Ratio

• Also known as a short interest to volume ratio, it denotes the relationship between the total number of stocks that are held short and their current trading volume in the market.
• It provides an insight into how well a stock is holding in terms of demand. A high ratio, therefore, indicates a stock's bearish trend. 

Short interest ratio

• It represents the relationship between the number of stocks that are shorted and the number of stocks that are currently afloat in the market.
• A high ratio may indicate a bearish sentiment and a possibility of a stock falling in price in the future, although this is not guaranteed. It may also lead to a short squeeze.  

When is Short Selling Profitable?

Short selling is profitable when a trader speculates correctly, and share prices fall below the market price at which a trader sold short. In that case, a trader gets to keep the difference between the selling price and the purchasing price as profit. 

Example – Rahul speculates that the current market price of stock ABC at Rs.200 is overvalued and expects that once its quarterly financial reports are out in a week, its share price will drop. He borrows 20 ABC stocks and sells them in the market at Rs. 200, thus getting "short" by 20 stocks. In a week, as predicted, the price of ABC stocks starts to fall and reaches Rs. 175. He then repurchases those 20 stocks at the lower rate of Rs. 175, thus pocketing Rs. 25 per share as profit and earning an overall profit of Rs. 5000 (Rs. 25 x 20). He then gives back those stocks to the original broker. 

Even though theoretically, Rahul profits Rs. 5000, in reality, there is interest on the borrowed stocks and commissions that investors have to pay. And depending on the timing of selling short, a trader might also need to pay a dividend to the buyer. 

Additionally, other traders might overtly short a stock, and it might deplete the stocks available with a broker. In that case, the borrowing costs might be steeper. Also, even after borrowing, there is no certainty that a trader will find buyers and sellers in the subsequent stages. 

When Does Short Selling Result in Loss?

When traders wrongly predict the decline of share prices, they stand to lose infinitely. The term "infinite risk" particularly applies to short selling, where the modus operandi is "sell high and buy low". 

In the conventional trading approach, a trader purchases shares at a specific price and expects them to rise in the future when she can sell them to earn profits. In that case, even if the share prices fall, a trader only stands to lose to the extent of his/her investment. This denotes limited risk as a result. In case of short-selling stocks, if the share prices surge, they can skyrocket infinitely as well. Hence, it exposes a trader to unlimited risk. 

Short selling example – Ruth speculates that PNM stocks will fall in value from their current market price of Rs. 100 when the company announces its dismal annual reports the following week. Relying on this speculation, she borrows 15 PNM stocks and concludes short selling in the stock market at Rs. 100/share. However, just after the announcement of the annual report, the company was overtaken by a reputed conglomerate, thus driving its share prices upwards to Rs. 110. Ruth then decides to close the position and buy back the shares at the increased market rate. She, therefore, realises a loss of Rs. 10/share, and Rs. 1500 (15 x 10) overall in addition to the interest and commission. 

Advantages of Short Selling

The main advantages of short selling are mentioned below – 

• The probability of substantial gains if the prediction of a price fall is realised.
  
• Margin maintenance, commissions, and dividends, if any, are the sole investments required to execute short selling.
  
• It can be used as a means to hedge against the downside risks of the securities or those related to them. 

Disadvantages of Short Selling

The disadvantages of short selling are – 

• Traders indulging in short selling are exposed to infinite risk, as opposed to the contained risk of conventional trading.
  
• Short trading involves borrowing from a broker, and that implies bearing interest on the borrowed stocks and also maintaining the margin. If the margin is not maintained due to market fluctuations or otherwise, the trader may have to increase funding or liquidate his/her position.
  
• Short selling is supremely time-sensitive. If a trader shorts stocks long before their prices drop, then he/she may have to bear the costs associated with short selling for a prolonged period. Conversely, if a trader shorts stocks a tad too late, then the chances that the stock has lived out most of the price fall are high.
  
• Traders are also prone to a short squeeze when buying back stocks. It typically happens when a stock has a high short interest. If a stock goes high and short-sellers start to close their positions (buy back the stocks), it drives up the share price and leads to a short squeeze. 

Difference Between Regular Investing and Short-selling

Shorting a company has its own set of restrictions that differ from conventional stock investments. This includes one that prohibits short sellers from driving down the price of a stock that has declined more than 10 percent in one day (compared to the previous day's closing price).

The risk of losses on the short sale is theoretically infinite. A stock's price could continue to grow indefinitely as well. Short selling is best used by experienced traders who understand the dangers/risks associated with it.