All You Need to Know About Short Selling [Guide for Beginners]

What is Shorting Selling?

Shorting is basically selling an asset without owning it. In this strategy, you actually sell the asset first and then buy it at a later stage to handover the same to the buyer.

Say for example, XYZ company has launched a new car worth 6 lakhs, and it has received huge demand from the public. As a result, there is a delay in the supply resulting in huge waiting periods. You booked the car and the delivery date assigned to you is after 1 month. However, the dealership has made it very clear that the effective price will be the price prevailing on the delivery day. After your booking, the waiting periods have further increased to 3 months. After 15 days, your friend tells you that he is also interested in buying the car and ready to pay 6 lakh 20 thousand to get an early delivery. Being a trader, you immediately inform him that you can give your car to him after 15 days, if he pays you 6.2 lakhs right now.

Now you have already sold a car for which you still don’t own. However, it is still not clear what will be the exact delivery price of the car on the delivery day. In case, if the price is below 6.2 lakhs, you have surely made a good profit. However, if the price is beyond 6.2 lakhs, you would end up in a loss.

This is called short selling. In the stock market, traders analyze a bearish phase and as a result, sell the stock at a higher price and but it later at a lower price. The trading and settlement mechanism of the exchanges settles every trade after T+2 days. This settlement time allows the trader to practice shorting.

Benefits of Shorting Selling

• Speculation: This is probably the first and foremost reason, why investors and traders practice short selling. When it is speculated that the market has an overvalued company or some announcements are expected which can bring a downward tend in the stocks of a company, a short position proves out to be the best way to extract some good profits. However, it must be noted that successful speculation is not an easy task and requires extensive research and timing.
• Hedging:Hedging is very similar to an insurance for your trades. If you have invested in the stocks of a company to make the most out of the dividends, but you are not sure about the future of the stocks of the company. What you can do is create a short position for the same number of stocks at the price you bought them. In this scenario, you will surely get profit in the form of dividend and the short position will protect your initial investment amount. If there is a decline in the price of the stocks, the loss you incur on your buying position will be offset by the profit you earn on your short position. In case of a bullish movement in the price of the stocks the scenario will be just inverse. In both the cases, you won’t lose money.

Risks with Shorting Selling

Like all other investment strategies, short selling does come with its own sets of risks. Some of the major risks associated with shorting include:

• Volatility:The stock market is very volatile. The movement in the price of a stock can change its direction in no time. Any stock which you have shorted and because it is moving bearish can turn out to be bullish any moment. It is important to research well to find out the appropriate support and resistance levels before shorting.
• Leverage Risk:Short selling, when practiced in intraday is often done by using broker limits or leverages. There can be huge risks associated with the investment when shorting is done using leverages.
• Manipulations: Short selling is often used illegal by market manipulators to deflate the prices of a particular stock or sector. This sudden selling in the stock increases volatility and increases the risk of destabilization of the market.