Classroom | What is short-selling and how can I profit from a fall in stock prices? (Equity: Part 10)

Part 10 of the Classroom deals with short-selling and explains how traders who have a negative view on stock can profit from a fall in its prices.

Whenever the market is falling, I hear about the term short-selling and short-sellers. Can you explain these terms?

Just like investors buy shares of a good company with the expectation that the price will go up in future, there is a category of market participants who may believe that the share price will fall in future. This could be either due to their negative view on the market or on the company. They could try to profit from this view by acting in a manner called as short selling. In this, the investor sells a stock today (at a higher price) and buys it in future (when the price falls in line with their expectation).

Please note that the selling can be done even if you don’t own the shares and hence the nomenclature ‘short’ indicating that you are short of these shares or that you don’t own them – still, you are selling.

Traders who short sell shares are known as short sellers. In market parlance, they are also called bears.

Is short selling a riskier strategy compared to the conventional method of buying first and selling later?

Yes, the risks involved are higher because if the price rises instead of falling, then technically, your losses can be infinite. Whereas, when you are buying, your loss is limited to the value of purchases even if theoretically the price goes down all the way to zero. If you short sold a share at Rs 50 and the price rose to 500 for whatever reason, you are staring at a loss of Rs 450. But when you buy a stock for Rs 50, at worst you will lose Rs 50 if the stock price falls to 0, or stops trading altogether.

How can I short sell shares?

One can short sell shares by either using the derivative (futures and option) route or by using the Stock Lending and Borrowing Mechanism (SLBM). When you are short selling through the derivatives route, you don’t need to own the shares at the time of selling. In SLBM, you can borrow shares from somebody who owns them, and then sell those shares. Of course, there will be a cost for borrowing those shares and you will have to return the shares within a specified deadline.

Do I have to keep margin money with my broker when I am short selling shares?

Yes.

How does one identify shares that can be short sold?

You need to identify stocks where either the overall business conditions or the individual performance will most likely deteriorate going forward. Stocks, where the prices are rising without any corresponding improvement in operating performance, are ideal candidates for short selling.

But remember, just because a stock is overvalued does not mean that you will be able to make money by short-selling it. Sometimes an entire sector can be overvalued because the market has taken a fancy to it. When that happens, every single stock in that sector, irrespective of its fundamentals, will do well. This was seen during the technology rally in the late 90s, when stocks from the media, telecom and IT services sectors rose to unbelievable highs. Short sellers lost money for a long time before they were eventually proved right.

Then there are cases where promoters collude with stock manipulators and manage to keep the stock price high for a long time though the fundamentals don’t justify the price.

As John Maynard Keynes reportedly remarked: “Markets can stay irrational longer than you can remain solvent.”

What is short covering?

Buying the shares back after short selling them is called short covering. Basically, you are covering those shares in which you were ‘short’ means you did not own them at the time of selling.

When too many short sellers try to cover their short positions at the same time, it can spark a rally in that stock.

Another set of market participants might often try to ‘squeeze’ short sellers by pushing up the stock price. These market participants could be existing shareholders, promoters, management or some other market manipulators.

The strategy—also known as short squeeze—is to create panic among short sellers so that all of them rush to cover their short positions at the same time.

More in this series:
Why markets exist, and should I invest in stocks?
Starting your stock market journey
Can I get rich fast by investing in shares, and other questions
How to open a Demat account and select a broker
Dealing with the stockbroker
Placing ordersWhere should I invest and how?