What is Short Selling? The Concept You Need to Know

Most investors buy shares hoping their prices will rise over time – buy low, sell high is the usual way to make money in the stock markets. But what if you could make money even when stock prices fall? That is exactly what short selling does. It is a strategy through which traders intend to make money from a decline in a stock’s price. They sell high and later purchase at lower prices.

Short selling means selling stocks you don’t own because you expect the price of that stock to fall. So, to make a short sell, you borrow stocks from your broker or through the securities lending and borrowing mechanism (SLBM), and sell them at the current market price. Later, you buy the shares back, ideally at a lower price, and return the shares you borrowed. The difference between your selling price and the buying price is your profit.

Let’s see with an example how short selling works.

Let’s say you believe the share price of Company X, which is traded at the NSE will significantly drop in the near future. The current market price of the stock is ₹1,000. Now since you don’t own the stock you decide to get your hands on them for a short period so you can short sell and make a profit. 

• So, you borrow 1000 shares of Company X from your broker and sell them at once at ₹1,000 each. You now have ₹10,00,000 in hand (₹1,000 × 10000 shares).
• A few days later, the price of that share falls to ₹800. Now, you buy it from the market at ₹800 each. This time you spend ₹8,00,000 to repurchase them, and return these to the broker.
• Of course, you have to pay brokerage, lendng fee and other charges that will reduce your net profit.  

Now, let’s see your profit: 

• Sold for ₹10,00,000
• Bought back for ₹8,00,000
• Profit = ₹2lacs (the brokerage and other charges are not accounted yet) 

However, if the share price had gone up instead of down — say, to ₹1,200 — you would have faced a loss. You’d have to buy back the shares at a higher price and return them, resulting in a ₹2lacs loss. 

One common question investors have – is short selling allowed in India? The answer is yes! Short selling is permissible in India with rules and regulations provided by Securities and Exchange Board of India (SEBI). There are two ways to short sell: 

Intraday Order (Cash, F&O)

The simplest way to short sell is through intraday trading by taking an intraday short position on the stock you expect will decline during the day. Intraday position means you are required to buy back the stock you sold during the same trading session. 

Futures & Options

You can take a short position for longer duration through futures and options. Traders often short stocks or even index through their futures contracts, or by buying puts or selling calls to profit from falling markets.

Securities lending and borrowing mechanism or SLBM

If you want to short a stock and keep your position for more than a day, you can consider using SLBM and extend your short selling. Through SLBM, you borrow the stock from other investors for a fee, sell the stock, buy it back to close your position and return the shares to the lender along with a lending fee.  

It is important to note, naked short selling is not permissible in India, which means if you can’t provide delivery of the stock you can’t sell it.

When investing in a stock, your loss cannot exceed what you have invested. However, with short-selling losses can be unlimited because there’s no cap on how high a stock’s price can rise.

Say you short a share at ₹1,000, expecting its price to fall down. But if the price of the stock goes up to ₹2,000 or ₹3,000, your losses could double, triple or even be higher making short selling a high-risk strategy. This is why short selling is only for experienced traders, who have a clear understanding of the market behavior along with a strong risk management system in place. 

Unlike buy low sell high, short selling is a strategy where traders make profit off falling prices of a stock or security. They sell the stocks they don’t own because they believe the price will fall. 

Short selling plays an important role in keeping markets efficient. It helps in improving liquidity, discovering true prices, and preventing bubbles as it gives investors a chance to act when they believe prices are overvalued.

However, short selling is not for everyone. It is best suited for experienced traders with risk taking ability who have proper market knowledge and strong risk management.