What is Short-Selling?

Short selling is a trading strategy that allows investors to profit from declining stock prices. In this approach, traders borrow shares they do not own and sell them in the market. The objective is to repurchase these shares later at a lower price. Investors use this strategy to speculate on price declines or to hedge against potential losses in their portfolios. This method carries significant risk, as losses can accumulate quickly if prices rise instead of falling. Understanding what is short selling stock can help traders make informed decisions in volatile market conditions. 

Example of Short Selling 

A trader expects Stock A to fall from ₹450. They borrow 10 shares and sell them for ₹4,500. If the price drops to ₹360, the trader buys back the 10 shares for ₹3,600 and returns them. The remaining ₹900 becomes the margin for gain before any applicable costs. 

How Does Short Selling Work? 

The short selling process involves several steps that traders must follow carefully. 

Step 1: Borrowing Shares:The trader borrows shares from a broker through a margin account. These shares are not owned by the trader. The broker typically charges interest on the borrowed shares. 

Step 2: Selling the Borrowed Shares: The trader sells the borrowed shares in the open market at the current price. The proceeds from this sale are held in the trader's account. 

Step 3: Waiting for Price Drop: The trader waits for the stock price to fall. This step involves market speculation and monitoring price movements. 

Step 4: Buying Back the Shares: When the price drops, the trader buys back the same number of shares at the lower price. This is called covering the short position. 

Short Selling Metrics 

Short-selling metrics help traders understand market sentiment and how heavily a stock is being shorted. The details below explain these metrics in simple terms. 

1. Short Interest: Short interest refers to the total number of shares that traders have sold short and not yet repurchased. It shows how much short activity exists for a stock. 

2. Days-to-Cover Ratio: This ratio compares short interest with the stock’s average trading volume. It indicates how many days it could take for all shorted shares to be covered if traders start buying them back. 

3. Short Ratio: This ratio compares the number of shorted shares with the shares available for trading in the market. A high ratio may show bearish sentiment, although outcomes are not assured. 

Advantages and Disadvantages of Short Selling 

A thorough understanding of what is short selling of shares requires examining both its benefits and drawbacks. 

Short Selling Tips and Strategies 

Successful short selling typically requires careful analysis, proper timing, and disciplined execution. 

• Trend Identification Traders can identify stocks in an established downward trend. When the stock price experiences a temporary rebound to a resistance level, traders may initiate a short position. The expectation is that the primary downtrend will continue after the pullback. 
• Strict Stop-loss Setting strict stop-loss orders on all short positions is essential. A stop-loss helps limit potential losses if the stock price rises unexpectedly. Stock prices can theoretically rise indefinitely, creating unlimited risks. Therefore, stop-loss orders are crucial for protecting capital. 
• Risk Control Setting defined risk levels can help traders avoid large losses. Discipline usually plays an important role. 

When Does Short Selling Result in Loss? 

A trader faces limitless losses if they make an incorrect prediction of the decline in share prices. In the case of short sales, when the strategy is to "sell high and buy low," the phrase "infinite risk" is especially applicable.  

In the traditional trading strategy, a trader buys shares at a certain price with the expectation that they would increase in value so the trader may sell them later on and benefit from it. In that scenario, a trader's risk is restricted since they can only lose as much as their investment, even if share values decline. If share prices rise against expectations while short-selling equities, they may do so indefinitely, exposing the trader to higher risk. 

What is Naked Short Selling 

Naked short selling involves placing a short-sale order without borrowing the shares or confirming their availability for borrowing. This can lead to failed settlements and may cause market disruptions. Therefore, this practice is illegal in many jurisdictions. 

SEBI announced that short selling will be permitted for all categories of investors, but naked short selling will remain prohibited. The regulator also stated that only stocks listed in the futures and options (F&O) segment will be eligible for short-sale transactions. 

What is Intraday Short Selling 

Intraday short selling allows traders to sell shares during a trading session with the intention of buying them back before the market closes. In India, this practice is permitted within the same trading day. 

If a trader sells shares but fails to deliver them by the end of the day, the trade becomes a short sale in delivery. When purchasing shares, traders must pay the full amount and take delivery through their Demat account. Similarly, if selling shares for delivery, traders must deliver these shares to the exchange. Failure to deliver results in the trade being classified as a short sell. 

According to SEBI, short selling is a process or technique of selling a security belonging to a seller who does not own the security. Normally, such kinds of strategies are opted for and followed by expert traders and knowledgeable investors. Short selling generally carries a high risk-to-reward ratio, meaning traders could potentially earn high profits but also face significant losses. 

Regulations for Short Selling Stocks 

Generally, short selling is allowed in India and most of the global markets. SEBI and stock exchanges set rules for borrowing shares, maintaining margins, and returning borrowed securities. If volatility in the market is high, then the regulator can put restrictions or may temporarily ban short selling to stabilise the market. Penalties can apply for settlement failures, regulatory breaches, or unauthorised short-sale practices. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance, financial objectives, and consult a qualified advisor before making any investment decisions. 

Conclusion 

Short selling, if practiced with care, allows traders to interpret price movements and control market exposure. The process involves borrowing, selling shares, monitoring changes in price, and covering positions according to prevailing market conditions. A trader typically uses research, risk controls, and tools available on a stock market trading app to successfully follow this strategy. A clear understanding of the process, metrics, and regulatory rules may support an investor in making informed decisions.