Short selling is the selling of a security which is not owned by the seller or any sale that is completed by the delivery of a security borrowed by the seller. It is the process of selling the borrowed stock in the hope that the price of the stock win fall, so that the short seller can buy-back at a profit. In other words short sellers expect to buyback the securities at a lower rate than the price at which they sold. That is, short sellers make profit when the stock price goes down. They involve a lot of risks and pitfalls.
Investors purchases stocks from share markets because they believe that a company has good growth prospects, above average management, an advantage on the competition, is undervalued, or for some similar reason. Selling a security short is done for the exact opposite reasons that securities are bought (long). Stated another way, the short seller sells a security that he believes will fall in value and then waits for the price to fall. If all goes as planned, he later buys the security back (covers the short) at a lower price and thus closes out (or covers) his short position at a profit. Thus, a short sale is simply a vehicle for making trading profits on the decline in the market value of a security, selling at a high price and later buying at a lower price.
Short selling is also considered as an advanced investment technique. Most of the investors misunderstand the process of short selling. Usually people think of investing as buying an asset, holding it while appreciates in value, and then selling it to make profit.
Illustration of Short Selling
ABC company’s stock is selling at Rs. 20 per share, and an investor believes that the price is too high and the stock will soon fall, so he decides to sell ABC short. He calls his broker and arranges to borrow 1000 shares of the stock, then he sells the 1000 shares short @ Rs. 20, receiving Rs. 20,000 in proceeds from the sale. He now has the money (held in his account as security) and owes 1000 shares to the lender.
Suppose the investor was right and the stock declines to Rs. 10 per share and the investor buys the stock (“buys to cover”) for Rs. 10,000 and delivers it to the lender. The final tally for this investment is:
| Short sale proceeds | Rs. 20,000 |
| Less: buy-back purchase | (Rs. 10,000) |
| Profit on trade | Rs. 10,000 |
Now, suppose that the investor was wrong, and the stock increases to Rs. 30 per share before he decides to cut his losses and buys 1000 shares to cover his short position. In this scenario the results of the trade would be:
| Short sale proceeds | Rs. 20,000 |
| Less: buy-back purchase | (Rs. 30,000) |
| Loss on trade | (Rs. 10,000) |
Whenever a broker enters a sell order of any kind, he must designate the sale as either a long or a short sale. A short sale generally occurs where the seller is not long the security being sold or does not intend to deliver an existing long position by settlement date.
The bottom line of short selling is figured in the same way, i.e.: a gain is realized if the security is purchased for less than it was originally sold for and a loss is incurred if the purchase price is greater than the sale price.
External Links about Short Selling:
- Short Selling: A Trader’s Guide (TradeKing)