What is Short Selling of Stocks? Advantage, Risks, Rules & Example

Short selling is a gamble.  What I have found out in my years of trading is that short selling pays off handsomely, well err only a few times.

First, what is Short Selling ?

This type of selling occurs virtually (especially in the stock and derivatives market) when you sell something that you do not have in possession i,e, not in demat account.

For example, you sell 10 quantity shares of Reliance, but you do not have those shares bought intraday before selling or already in demat .

How can you Short sell in Cash and Derivatives market? Why is this type of action called Short Selling?

In cash market its simple as selling the shares at any point of time before the cut off (as mandated by SEBI rules when you  can initiate no more new short positions). Note that this is called Short trading because you are selling shares which are short of corresponding buy positions.

So, you have sold the shares which you do not have in your demat, or your selling quantity is more than the bought positions in demat. You sold the shares predicting the price of those scripts will come down soon. In reality, two events  can occur.

After your short sell, the price may come down, as you envisaged. Or, It may reverse and go up.

 If it slides , you will be in profit. If it moves up, you will suffer loss.

Short selling happens differently in the cash and in the derivatives market. Short selling is a risky gamble which can destabilize any cash market.

Rules of short Trading in the Cash market

So, in India, under SEBI, the rules are that you have you mandatorily buy back the shares that you have "Shorted" on the same day within 3.00 PM. If you don't do, your broker will square off (buy) your positions automatically , without your consent, at 3.15 PM at market price.

What does the above statement mean?

It means that you have to buy back that quantity of shares  which you had sold without having any corresponding buy quantities in the morning. As per SEBI, you cannot have any open positions of Short quantities i.e. simple Sell positions  of share, at the end of the day.

However, you can short or sell position is derivatives without any such bars.

Real life example of short selling in the cash market

Let's explain Short Sell  through a practical example.

You Short sell Infosys (say  5 shares ) at Rupees 1300 apiece. That means y have sold 5 shares of Infosys, but you do not have corresponding buy positions.

Your view at the time of selling was that the USD (dollar ) have already appreciated too much. If the dollar strengthens/go up verses Rupee, shares of IT firms with strong overseas presence like Infosys, TCS (who receive a major portion of their revenue in dollars) , tend to move up.

However, if Dollar weakens and moves down, Infosys share price logically follows the same downward path.Ths happens because it's assumed that their revenue will also come down with the weakening of the dollar.

Now , let's carry on with our example. You thought that Dollar had moved up too fast, and will come down that day. Henceforth, 3 things can happen. It can be so that the dollar really moved down but Infosys did not react as you expected and it moved up by 20 rupees at 3 pm. In such case, you will suffer a loss of Rs 20 per share when you have to mandatorily buyback/close your Open short positions of Infy at 3.00 pm . That’s a total loss of Rupees 100 excluding other charges.

Else, Infy moves down by Rupees 10 soon after. You square off your positions at a profit of rupees 10 apiece. Your gross profit is Rs 10 * 5 shares = Rs 50, excluding other charges.

Infy price comes down by Rs 5 soon after. You do nothing, overconfident it will slide more. Price reverses, crosses Rs 1300 and reaches Rs 1320 at 3 PM. Your position is squared off automatically and you suffer a loss of Rs 20 * 5 = Rs 100 on this Short Sell trade.

Shorting in the Derivatives market

In Derivatives, the procedure is a bit different. Here you cannot sell one or two shares of that entity.You have to sell in Lots i.e. a specified number of shares which usually runs from hundreds to thousands per Lot. The number of shares in a Lot is pre-determined by SEBI. For example, a derivatives lot of share like Unitech which was trading below Rs 10, had a lot size of 8000 shares (when it traded in the futures market).

You can Sell a lot of any script in Derivatives/Futures market without caring a hoot. Here you need not close your position at day end but can carry it till the expiry date for that contract. The only hitch in this is that you have to make up the market to market loss (if any) you suffer, for total quantities of that lot at end of trading, every day.

This will go on until you have the open positions . If you make a loss, you pay extra money to cover it. If you profit from short selling a futures position at end of a day, the money is added to your account. There is no need to close or square off your position in futures , till expiry and till you have the money to cover your loss.

In India, why can we Short sell ( Sell quantities of an entity without having corresponding Buy positions first) in the Derivatives but not in the cash market?

The answer lies in the way the Cash and Derivatives/Future market are settled.

 The cash market is settled by actual positions while the derivatives market is settled by paying the market to market profit or loss.

 In cash market you can only sell the shares that you physically possess, but in derivatives market, you ultimately close your positions on expiry by paying/taking in cash the total margin money and the profit or loss that you have suffered due to your position. There is no physical settlement of positions.

 In a nutshell, for derivatives,  you do not need to have the physical quantity pre-bought , which you will furnish at the time of expiry. However, what you have to provide is the margin money and enough amount to cover your market-to-market losses.

Short selling in derivatives is dangerous. Warren Buffet has famously called derivatives market a destroyer of wealth, and this happens mostly owing to short squeezing.

Short Squeeze

In short-term trading, there's a term: Short Squeeze". This refers to a position in which there is a huge quantity of Short Sold positions while the buying position is minuscule in comparison. May God save you , if you also a participant in those shorted shares, Because , if the price reverses, there is a mad rush to take whatever profit one can before the price rises too high, and because bought quantities are not available in sufficient numbers , people buy at whatever price the stock is available. This causes the price to shoot up like a rocket. And people get trapped in the short positions. They then buy or square those off at whatever fancy prices the buyer demands, at heavy losses.

Pros and Cons of shorting

Advantages of shorting

When you are sure that a script price will slide, and you do not have the shares, short selling is the only way to profit. This type of trade is best for some quick profit when you sense that a share price has risen too much or ann adverse event is going to occur. You can also follow the Technical analyzers like RSI or MACD oscillator or follow the Moving averages to decide when to short sell.

However, the Cons of Short selling outweigh the Pros. In short selling, you can never be sure when the price will reverse. Believe me, it happens so in 80% of the cases that the price of the script reverses at some point of the day. The news for which the script fell might turn out to be no news at all, and then the script reverses and takes an upward trajectory. If you cannot square off your selling positions at this point in time, you will suffer heavy losses. In case of short selling, you gamble and depend on your luck. Most of the times, your gamble will not pay off.

What are the strategies I should follow for short selling?

Short selling in futures or in the cash market is not advised. The problem in the futures market is that you cannot carry forward the intraday position. In derivatives, the problem lies in the fact that although they are meant to be carry forward, the loss suffered owing to the large quantities in a derivatives LOT of that script, makes it untenable to hold your positions if the price rise continues.

So there are only two strategies that you can apply when trading Short.

Be fast and quickly take some profit off the table if the price suffers a downfall soon after. Try to make some profit whenever the price hurtles downward so that you are at breakeven even if the price rises after that downward movement.

Another way is to take off the entire profit fast whenever you get even a small downward movement after short selling.

Another way you can tackle the situation is to apply Stop-Loss.  This will help to curb your losses and save you from getting burnt if the price suddenly shoots upward. If you ask me, this is the best strategy of the lot. Place a stop loss and wait patiently. If the price moves down, square off and pocket the profit. If the price doesn't  do so and moves up instead, your stop-loss will protect your capital from getting eroded too much. You will live to trade another day. Who knows, you may hit the jackpot the next day.

Do not take too many positions in Short Trade.

Conclusion

I would advise you not to Short Sell, especially in the cash segment. Trade like an investor . Wait and buy when at low, and sell at highs. Trading is a strategy game after all and not a gamble.