The basic of short selling in stock market

June 16, 2010

What is short-selling?

Short-selling is the sale of shares that the seller does not own at the time of trading. Despite being a long-standing market practice worldwide, short-sales have been the subject of considerable debate and divergent views in most securities markets.

The first thought popping up in your mind would be where do these shares come from which you are selling without possessing them in your portfolio of stocks. These come from your broker/brokerage firm that lends you the shares in lieu of your investment as collateral. You short sell these shares but subsequently you have to close the short by buying back the shares from market and then return it to your broker/brokerage firm. You are also charged some interest for the loan of shares you have taken.

Looking at the flow of shares in above flowchart, one would ponder why to borrow shares for selling in market and then transfer them back to the lender? The logic behind shorting is very simple; earning profit margin. Lets see how??

If you think a stock is overvalued and expect that the price would come down in future for sure; you would wish to sell the shares at current levels at higher price. So you borrow the shares and sell them at higher price. And when the stock actually falls as you had speculated; you buy it from market at lower price and return it to the lender and the difference between the selling price (higher) and buy price (lower) is what you earned in the deal. So at the end you must close the short by paying back the shares and this is called as covering the short.Concluding this , investors who anticipate fall in the stock price go short to take advantage of market fall. An investor can hold the short for as long as he wants but he is charged an interest as it is similar to a loan taken in the form of shares. Also if during the course of loan, the company declares dividend or rights issue, it must be paid to the lender who is the actual owner of shares because you are just a borrower.

Short selling is considered to destabilize markets directly or indirectly. In 2001, the stock prices crashed heavily owing to short selling by big operators after which SEBI banned it. After a gap of 6 years in December 2007 SEBI came up with updated norms of short selling to cover the loopholes and ultimately institutional investor were also permitted to short sell.

Concluding this, short selling no doubt gives you an opportunity to earn profit by taking advantage of downturn of markets, it might bring in huge loss to your investment if stock price moves up. Because in real sense, shorting is a bet against the current market trend. When stock is at current higher levels, you are expecting it to fall down and entering the arena. Speculation is what makes shorting a riskier job. So beware of the dark side of shorting before you actually go for it!