What Is Short Selling in the Stock Market?

Short selling is a volatile trading strategy where it is possible to make profits from the fall of a stock's value. Short selling entails selling shares you have that do not belong to you unlike buying stocks and hoping their price goes higher. It can be rewarding but may also risk being very highly risky; thus, a tool every investor must fully understand the mechanics and implications of short selling before he employs it. In this article, let’s learn what is short selling, how to short a stock, and the advantages and disadvantages of short selling in detail.

How Short Selling Works?

Let’s now understand how a short selling works. The step-by-step process is as follows. 

1. Borrow shares: The investor will borrow shares from a broker and pay the requisite fee. The broker will likely ask the investor to provide collateral in cash or other securities.
2. Sell shares: He sells those borrowed shares on the market at the prevailing market price immediately after borrowing them.
3. Wait for price fall: The investor waits for the falling price of the stock. This could take a period of time depending on the current market and news about the company.
4. Buy-back shares: Once the price of the stock has gone down, the investor buys back the same number of shares at that down price.
5. Return shares: The investor returns the borrowed shares to the broker.
6. Profit computation: Profit will be calculated as the difference between the selling price and purchasing price, adding borrowing fees and other trade costs.

Example of Short Selling

Now, that you understand the short-selling meaning, let's look at a short-selling example to be able to understand the meaning of short-selling better. Assume you believe the price of Company XYZ's stock is too high at ₹1,000 per share, and you expect it to fall soon. You decide to go for short selling of 10 shares.

• Borrow and sell: Borrow 10 shares and sell them for ₹10,000 (10 shares x ₹1,000).
• Price falls: After a week, due to negative market news, the price of Company XYZ's stock drops to ₹700 per share.
• Buy Back: Buy the 10 shares you had sold for ₹7,000 (10 shares x ₹700).
• Return Shares: Return the borrowed shares to your broker.
• Profit Calculation: Your profit is ₹3,000 (₹10,000 - ₹7,000), minus any interest or fees charged by your broker.

This example shows how shorting a stock works if you correctly predict that a stock price will fall.

What is Naked Short Selling?

Naked short selling means selling shares short with no attempt to borrow them or evidence they can be borrowed. This causes diverse problems in the market, as there will be failed shares on settlement dates. Naked short selling is mostly prohibited in most countries because it imposes artificially created pressure on stock prices and manipulates the market.

What are Short-Selling Selling Metrics?

There are a few metrics through which investors quantify short selling and measure the potential risks. A good understanding of these metrics, along with what selling short a stock means, is vital to implementing this strategy. They are as follows:

• Short Interest: The total number of shares sold short but not yet covered or closed out. High short interest is usually a sign of bearish sentiment in the share among investors.
• Short Interest Ratio: The number of days a short position can take to be liquidated is calculated by dividing the shares short sold by the average daily trading volume.
• Days to cover: This metric depicts the number of days it would take for all short sellers to go long given the average trading volume. The ratio is high if it takes a longer time to unwind the position for shorts if they are interested in covering quickly.
• Borrowing Costs: The cost of borrowing shares to sell short; usually based on the demand for the shares borrowed and how many are available in the market.

Understanding these numbers in a way that allows investors to consider whether a stock might come under upward pressure if there are a lot of short sellers trying to cover at the same time.

Advantages and Disadvantages of Short Selling

Short selling represents pros and cons that should be weighed out by the investor before engaging in the practice. Here's a table that collates these benefits and drawbacks.

Conclusion
One of the unique investment strategies, short selling, is a method through which investors can take advantage of falling stock prices with equally important mechanisms to market efficiency and liquidity. One can implement the strategy using a share market app. It, however, entails serious risks such as unlimited potential losses and all those complex regulatory requirements that make it unsuitable for investors lacking experience or risk management systems. It can be a useful tool for hedging or capitalizing on market inefficiencies, but it's important to exercise caution while trading.