In the stock market, traders buy common stocks to sell them at a higher price to make a profit. This type of trade is completed with a buy order and then followed by a sell order. This means, if a trade is entered with a buy order, then it will be exited with a sell order. Short selling is opposite to this process. This means a person takes a short position if he expects that the price of the security will decline. In short selling, the trader enters with a sell order after borrowing stocks from the broker/lender and then exit with a buy order when share value comes down.
Understanding short selling concept
When stock prices are expected to go up, you can benefit by buying stocks at the present level and then sell them later for a higher value. But, what happens when you expect the stock prices to fall from the present level? In this case, if you have enough money, you can buy the stock after its fall and then sell it at a higher level to make a profit.
What if you don’t have enough money to buy and sell that stock? In this type of situation, traders use short selling. Instead of buying and selling stocks, what these people do is that they borrow stocks from the broker/lender and sell them at present market price to buyers willing to pay the market price in order to buy at a future date when the price decreases. After buying at a lower value, they return it to the broker/lender from whom they have borrowed.
The main reason for taking a short-selling position is that you believe that the market price will come down in the future. If it happens, you can buy stocks at a lower valuation and then return it to the lender. If it didn’t happen, you will be buying stocks at a higher valuation resulting in a loss for you. This means in short selling, traders are betting on the prices of a stock that they believe will drop in the future.
Here are the steps in short selling;
- The trader borrows stocks from a broker;
- Sell those stocks in the open market to get cash;
- Wait for the stock to fall;
- Buy the stocks back from open market to return it to the lender
Suppose stocks of XYZ limited are overvalued and its price will drop due to market volatility. On the basis of this assumption, you place an order to sell short 1000 shares of XYZ limited at a price of Rs 400 per share by borrowing shares from your broker. Brokerage firms can either get these shares from its own inventory or from other brokerage firms. Now the brokerage firm in your margin account will show the value of shares you borrowed minus commission of the brokerage firm. The brokerage firm on the basis of your order sends these shares to a buyer. When the stock of XYZ decline to a lower level, you put a buy order to cover your short position. Suppose you bought 1000 shares at Rs 350 per share, this means you made a profit of Rs 50,000 (Rs 50 per share) minus commission and interest charged on the margin account by the brokerage firm. 1000 shares that you borrowed from your brokerage firm is now returned.
Short selling is transacted in your margin account as protection in case you default on the short sale. On this, we suggest you contact your broker as they may charge interest on the value of the borrowed shares while the position is open.
If the stock’s price falls below its short sale price, you make a profit. On the flip side, if the stock’s price increases instead of falling down, you lose money. Your loss will go up based on the increase in the market price of the stock.
In our above example, assume that the stock of XYZ limited has gone up to Rs 550 per share instead of falling down as per your expectations. In this case, you have to buy the stock at a higher level to cover your short position. If you bought XYZ limited shares at Rs 550 per share, then you are losing Rs 100 per share plus brokerage commission. This means, the higher the price, the greater the loss and lower the price, the greater the profit.
In short selling, you are not the owner of the securities as you have borrowed it from someone. Hence, the short seller is required to pay any dividends that are declared by the company to the owner of the borrowed securities.
How a stop order can protect profit/loss in short selling
In stop order, you instruct the broker to buy or sell a stock after it reaches a specified price. After reaching the specified price, the order becomes a market order.
This type of order can be used to protect your profit or loss in short selling. Suppose you sell the stock of XYZ limited at Rs 400 per share and the stock declined to Rs 380. Now you have two choices: you can either buy back the short position or wait for a further decline to buy at a lower level. At this juncture, if you want to protect your profit against an unanticipated price hike, then you can place a stop order at Rs 385 to preserve profit of Rs 15 per share.
Similarly, you can use a stop order to protect losses in an unfavorable short sale. In our above example, you can place a stop order at Rs 410 to limit your losses at Rs 10 per share.
Key pros and cons of short selling
Short selling requires you to have a margin account with your broker. It allows you to borrow money from your brokerage firm by putting your investments as collateral. Short selling is very risky as there is no limit of loss if the stock continues to go up in value. whereas, if you go long on a stock, at least you have a chance to lose up to the amount that you have invested. Below is a summary list of the pros and cons of going short;
- Probability of higher profit in a short time, if you are sure that the stock’s price will drop in the short term.
- Less capital required to get started.
- It can be very costly if the trader guesses wrong about the price movement
- To undertake short selling, you must have a margin account with the trader
- Commission and interest as the cost of margin account can take out your whole profit
- Chances of losing 100% of the capital, if stock rise to beyond your imagination
- Highly risky than going long on a stock