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What is Short Selling in the Stock Market

What is Short Selling in the Stock Market?

In any stock market, we normally find 2 types of dominant traders

  • Bulls
  • Bears

As most of us are aware the Bulls are traders who think that the prices, of Equity shares in markets, will rise, thus they always buy first and sell at a higher rate.

On the other hand, there are Bears, who always have a negative view on the prices, feel that the prices have risen abnormally and therefore are always look at selling stock and buying them at a lower price.

 

What is Short Selling in the Stock Market

What is Short Selling?

Short selling in the stock market is a trading technique in which you sell any stock without actually possessing it, with the intention to buy it back at a lower price.

The people short selling stocks could be Traders, Hedgers or Arbitragers. When they feel that the price of a particular stock has risen too much or that a stock looks artificially priced they will short sell that stock. They also take advantage of a falling market, when the prices of all stocks are coming down, to short sell any stock or the Index.

 

The need for short sellers

As there are traders who first buy and then sell at higher prices, there are also traders who take a contra view and will always sell first and then buy at a lower price.

As the Bull’s take the stock prices up it is the Bear’s that keep these prices in control by short selling the stock.  They bring sanity to a frenzied market, and most importantly they ensure volumes in the market. They make the stock markets dynamic.

Imagine a Bulls market, where everyone just wants to buy and the sellers are waiting for a higher price to sell. The stock market will move just one way, up, and when the buying is exhausted it will become dull and will get stuck at a particular level.

So what makes the stock market so dynamic are the buyers and sellers. Without either of these, the share market will lose its mysterious nature and become very predictable which is not healthy. A monopoly of buyers or sellers will not lead to healthy growth in any economy.

 

Settlement of short selling

As you know, a short seller is a trader, who always will find the prices high and will sell first and then buy at a lower price. A short seller can trade in the cash market as well as in the derivatives market.

A short sell trade in the cash market i.e. the shares which are sold have to be bought back the same day, before the end of the trading session. So a cash market short sell has to be squared off on intraday basis only, such trades cannot be carried forward to the next day.

However, if due to any reason the short seller does not square off or cover his position on the same day, he is bound to give delivery of the shares, he has sold, on a T+2 settlement day of the Exchange. If the trader does not have the delivery of the shares short sold he may have to borrow from someone and give delivery or his position will get auctioned in the market on a T+3 basis and a penalty may be charged to him by the Exchange for his default.

Auction of shares takes place when a seller of shares in the stock market cannot give delivery of the shares sold on a T+2 settlement day.

As you are aware for every buy trade there is a sell trade and vice versa, so the buyer of these shares will demand the delivery of the shares from the seller.

If the seller cannot give delivery, the buyer demands the delivery from the Exchange, as he has paid the delivery money on his buy trade on T+2 settlement day. So it is the prerogative of the Exchange to provide the shares that the buyer has paid for.

When the seller is unable to give delivery, the Exchange holds an auction of these shares, at an auction rate which is normally higher than the market rate of the shares, on T+3 basis and any other person can give delivery of the shares, wherein that person will get higher than the market rate for his delivery. The difference between the auction rate and the actual sell price of the original seller is the loss that the original seller will have to bear plus the Exchange may charge a penalty for the short sell transaction because it was not delivered.

A short sell trade in the Derivative segment, either in futures or options, can be carried forward till expiry day i.e. the last day of the settlement. On the expiry day, it will be automatically squared off by the Exchange, if it is not in the compulsory physical list.

If it is in the compulsory physical settlement list then it will be settled by the trader, giving delivery of the shares. However, the short seller can square off his trade at any point during that month if the price has moved lower and he is making a profit or if the price has moved higher and his stop loss gets triggered.

 

Risks involved in Short selling

risks in short selling

Short sellers create the necessary volumes in the stock market by continuously supplying the stock even though they do not possess them. The short sellers make money in the derivative segment when the markets react negatively to any economic, political or company-specific news. So even if the market is on a high nowadays, short sellers are also making money daily and may make even more if the markets come down temporarily or turn bearish for some time.

As we have seen it is very risky to short sell in the cash market, as in case the price of that stock does not come down the short seller will not make a profit but rather make a loss, if during the day there is more demand in that stock and the price keeps going up. The short seller will have to square off his position intraday only or face an auction, where the loss is much higher.

There is a lower risk if short selling is done in the derivatives segment as you can always carry forward your position even if the price moves up on that day. You may wait for prices to come down anytime during the month and there is no auction involved.

The least risk will be to buy a PUT option of any stock or Index, as a form of short sell where your loss is restricted to the premium paid.

 

What are Covered and Naked Shorts?

A covered short position means that the short seller has some way of getting the delivery of the shares sold maybe from his broker or a friend. Thereby he is covering his short position with delivery, in case the price does not move downwards as he expects so he will not square off his position but give delivery of the shares and buy them back after a few days or weeks when the price goes down and return it to the person he had borrowed the shares from. This strategy works very well for the cash market short sellers and allows a low-risk trade.

Naked Shorts are short selling positions taken without any backup of delivery. The short seller has to cover the position before the end of the day, in case of the cash market, or on expiry day, in case of derivatives segment. This is a very high-risk trade as if the price of the share moves up there is a sure shot loss for the short seller.

 

Who can short sell?

SEBI has allowed the Exchanges to permit any person to short sell any stock in the cash market and a specific number to stocks listed in the derivative segment.

Any trader can short sell any stock in the cash market, but not the Index, on an intraday basis. e.g. recently in the news, we had Jet Airways shutting its operations and as an effect of which the share prices were bound to react negatively, so any trader short selling the stock even in the cash market would have benefitted as the price moved down intraday by almost 30%.

Same is the case in the derivatives segment as there is no restriction on short selling any stock and including the Index.

So as a trader you want to experience short selling please go ahead and try it but only after studying and understanding all the risks involved and with less of a risk if done in the derivatives segment.

 

Security Lending and Borrowing Mechanism (SLBM)

In India, the SEBI asks the Exchanges to recognize short selling as a trading technique and has officially allowed short sell and has also taken steps to reduce the risk involved in such trades. As we have read earlier short selling is a high-risk trade and thus, to reduce the risk of a naked short sell, have introduced the SLBM segment, the Securities Lending, and Borrowing Mechanism.

Under this segment the short sellers and borrow shares from investors of such share, at market rate plus interest on the value of the shares, to give delivery on settlement day and buy them back and return to the investor within a time frame of a fortnight or a month.

This not only reduces the risk of naked shorts, but it also protects the short sellers from intraday losses and creates a supply of shares in the market, which otherwise would lay dormant in the investors’ demat account.

The short seller will have to pay a small interest on the value of shares borrowed but for the investor, it is just his holding given on loan to somebody.

This mechanism has not yet found many takers in the markets as the derivative segment allows short selling to be carried forward easily.

 

Benefits of the short selling

short selling benefits
Though short selling by many is considered as negative trading the short sellers do not allow the share prices to rise by continuously by creating a supply for that stock. The short sellers benefit the stock market in more than one way.

Even though short selling is very risky and these short sellers do not create any value for the economy but it is only due to them that every overpriced stock of a company finds its true value in the Stock market.

They are traders who react when the prices of companies in the stock market start moving up without any legal reason. These traders keep tab on all rising stocks and after the price reaches a high or attains the price which is the actual worth of that company based on its Balance Sheet, they will step in and short sell the stock creating an artificial supply to the demand, after which the demand slows down and the price is corrected.

 

Conclusion: Short Selling in the Stock Marke

Imagine if we had only a Bull market all the time, then after a particular time, the prices of stocks would stop increasing, on reaching their full value and then the market would not be as exciting or as dynamic. It is only because of these two-sided cycles, of ups and downs, that make the stock market so unpredictable and thus no one can master it.

 

Related Questions

Can we short sell in the Indian market? Yes, SEBI has allowed the Exchanges to permit any person to short sell any stock in the cash market and a specific number to stocks listed in the derivative segment. Any trader can short sell any stock in the cash market, but not the Index, on an intraday basis. In the derivatives segment as there is no restriction on short selling any stock and including the Index.

Can I do short selling in Zerodha? Yes, you can short-sell in Zerodha. Officially you can short sell any stock in the Cash segment on intraday basis and in the Derivatives segment on a carry forward basis. However, it depends on broker to broker which stock they would allow short sell. So it is always better to check first and only then short sell.

 

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Soujay Shah

Soujay Shah is associated with the stock market since 1992. With over 25 years of experience now trains people on ways to make money in the stock market. He is a SEBI Registered Research Analyst and has certification in NISM for Equity, Derivates and Currency segments. He is a practicing Numerologist and Tarot reader.

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