What is Short Selling and How Does It Work

Short selling is a stock trading strategy to make money from the fall in the stock prices. It is opposite to normal share trading where you buy stocks at low price and sell them later on at higher price to earn profits.

We generally see that stock prices and stock markets move higher slowly and steadily over the time periods. However, in negative sentiment environments, the price fall is very ferocious and rapid. Thus, short selling offers a very good tool to make large money in short times.

Short selling was considered illegal and was banned in earlier times. This was because the critics always argued that it leads to undue pressure on the stock prices and unrequired price falls. However, short selling was made legal in 1937 in USA. But in case of major falls due to short selling, the stock exchanges may impose short selling restrictions to prevent further price falls.

Short selling has its own advantages and risks associated. We shall find out how does short selling work to create more trading opportunities for you.

What Is Short Selling

Short selling or shorting a stock is the strategy of selling a stock which you don’t own and later on buying that stock to square off or close your trading position in the market. Your profit or loss is the difference in your selling price and buying price.

This is totally opposite to what we normally do in stock trading to make money. We buy stocks at low price in a hope to sell them later at a higher price. The difference between our selling price and buying price is our profit earned. This strategy of buying stocks at low in expectation of selling them at high is called as ‘going long’ or ‘long position’.

But the stock markets and the stocks do not move in a straight line. If they go up, they come down too. What would you do at that time? Would you keep waiting for the markets and stocks to start moving higher and then start trading? Would not that be a wastage of your time and trading opportunities in the stock market? Would not that be great if you could utilize market falls or stock price falls for making money in falling markets too?

Here, the strategy of short selling comes into play. Here, we can borrow the stocks from our broker at a certain price and short sell them in hope to buy back those stocks at a lower price and return the stocks back to broker. The difference between selling and buying price is our profit. This is called as ‘short selling’, ‘going short’ or ‘short position’.

The difference between going long and going short is that in former, we sell only the stocks we own while in later, we short sell the stocks we borrow from the broker to sell and buy them back to close our position.

Professional traders use short selling for various purposes. It can be speculative trading to make money in falling markets or to protect their long term stock portfolios from fall in stock prices.

How Does Short Selling Work

Now, how do you borrow a stock to short sell?

You just have to login to your online trading account. Select margin trading option out of cash/margin options in the ‘place order’ page of the equity section of your account. Select action as ‘sell’ along with the stock code and the desired quantity you want to short sell and place your order. That’s it. You do not need to go anywhere to borrow a stock to short sell.

After your short selling order is executed, your short position is created. You should put a stop loss which is above your shorting price. When the stock moves lower to your target, you square off your position and exit the trade. The stocks are automatically bought back and returned to the broker and the profits are credited to your trading account.

Shorting can be done for any security; it can be stocks, currencies or commodities. We shall be talking about short selling of stocks for understanding purposes.

Short Selling Example

Let us understand how short selling works with an example :

You can look to short a stock if you expect it to fall lower from current market price. Suppose a stock XYZ is trading at $100. You expect the stock price to fall towards, say, $95. You also expect the stock to not move above,say, $102 which makes it your stop loss for the trade.

Suppose you want to short 1000 shares. You would login to your trading account. Place your sell order for 1000 shares in the margin segment as seen in the above figure. After the order is executed, you would place your stop loss order at 102 to limit your losses in case of unfavourable share price moves.

If the stock declines to $95, you can buy back the stock by squaring off your position to exit the market.Your profit is $100 – 95 = $5 per stock or $5000. If the stock does not move lower but moves higher and triggers your stop loss, you would incur a loss of $102 – 100 = $2 or $2000.

There are different opinions regarding short selling. Some people consider it illegal. This is because the short sellers are betting on falls in stock prices. Falls in stock prices indicates profit of the companies as well business going down. Short selling exaggerates further fall in the stocks and markets and more volatility in the markets. So they want a ban on short selling of stocks.

But there are advocates for short selling too. They are of the opinion that it keeps stock prices in check. It adds versatility to trading and allows making money in market downfalls too.

Whatsoever their opinions, it should be remembered that short selling is highly risky.

We took an example of shorting a stock above. To the maximum, this stock can fall to zero. So maximum profit you can make by short selling this stock is $1,00,000. Contrary to it, the stock an rise to any value if there is any sudden big positive news. It can go to 1000, 1500, 2000, 5000 or infinity. Those are the losses you are exposed to because rise in stock price is a loss for short seller.

So, theoretically , you are exposed to unlimited risk with limited profit potentials.

I am not saying that you should not go for short selling. With stop loss in place, you are very much protected.

It can happen with overnight positions when you carry home your short position to next trading days. Anything can happen in the stock market. It is a stock market. it can happen with long position too.

But with proper planning and trade management, you can go for short selling to make handsome money in falling markets too.

How To Short A Stock?

You can not short sell a stock in cash segment. This is done in margin trading only. All trading accounts offer you trading in cash as well as margin. So you do not need a separate account.

With margin trading, though, you can hold your trading position for more than one day for a buy order, this is not possible with short selling. Shorting in margin can be done in intraday trading only.

With the incorporation of futures & options in the markets, the things have been made quite easy.

Futures & options trades operate in the form of contracts which remain valid for a month. So, you can hold your short position till the expiry of that contract which roughly corresponds to four weeks when you will need to square it off or roll over to next month.

So short selling provides you unique tool by which you can play the markets for downside also to earn the profits and you need not to keep waiting for market up move when you will initiate your trade.

In fact, shorting has the potential to make huge money very fast when the markets are in panic and collapsing because people exit the markets very fast than buying.

But you need to be very careful too when shorting a stock and go short only after your thorough research.

General tendency of the people in markets is to buy, so you might get caught on wrong foot if you leave any loophole. Hence, experts advise that short selling be done by professional traders only.

You can short a stock by three methods –

1. Margin Trading

2. Futures Trading

3. Options Trading

Short Selling in Margin Segment

As we talked earlier, you can short a stock in margin segment in intraday only. You do not need a separate margin account for short selling. The same trading account offers the option for cash trading as well as margin trading.

You can short sell the stock in margin trading like we talked above with the example and shown the above figure.

Short Selling in Futures Trading

If you want to keep your short position for more than a day, you can opt for Futures Trading.

With futures trading, you can keep your short position as long as you wish, even for more than a month if you have little long term view on stock price. At the end of a contract month, you would need to roll over your position to next month contract.

To short a stock in futures, head over to F&O or Futures & Options section in your trading account.

Look for the stock futures you want to short by moving over to “Place order’ link.

Click on ‘Sell’ link against the futures contract you want to short.

Place a stop loss order by following the steps we discussed above.

It is advisable to tell you that futures trading is very risky for your capital. You should learn the basics of futures trading before you go for it.

Short Selling Stocks with Options Trading

You can also short sell a stock with options trading. Options add more versatility to your trading arsenal.

Options are comparatively safer method to short stocks depending upon the method you choose.

There are two ways you can use options for shorting a stock :-

Buy Put Option

This is the safest method to short the stocks. You will simply buy a put option for the stock you want to short. You can hold it for one month contract time.

The risk with put option is limited and profits can be unlimited. At the maximum, you can loose only the ‘Premium’ you pay to buy an option.

Learn how to find a cheap option to buy to reduce the losses and increase the profits.

Lets take the above example again. The stock is trading at $500. You expect the stock is likely to fall towards $490 or 480 in a day or few days. Also, you believe that the stock may not move above $505 during this time.

You can simply by a put option. Look for the various strikes available for that stock trading.

Suppose you found the 490 strike put option which is trading at a price of $10. The ‘Lot Size’ for it is suppose 100.

You can buy that put option for a premium of 100 X 10 = $ 1000. If the stock falls as you expected, the option price will start rising.

Say, the stock price falls towards $490, the put option price may move higher towards $15. Then you make a profit of 15 – 10 = 5 X 100 = $500.

But here is the catch. Though it is a method with limited risk but still maximum people loose money by buying options only. The reason is the ‘Time Value’.

Read about option pricing to minimize your losses in options trading.

Sell Call Option

This is another method for shorting a stock. Here you sell a call option of higher strike than the current price of the stock you want to short.

The price of a call option increases if the stock rises and decreases if the stock falls.

Similar to the above example in put option, you will choose a call option for the stock.

Suppose, you have a call option of strike 500 which is trading at $10. When the stock price falls, the price of call option will fall lower, say, to $5.

You sell the call option at 10 and buy it back at 5 with a net gain of $5. Again you make 100 X 5 = $ 500 when the stock price falls.

Learn how to make trading more profitable by Option writing or Option selling.

But, it is important to remember that with selling options, you have unlimited risk and limited profits. Also you need higher margin amount to sell an option than buying an option.

In the above example, your maximum profit can be 10 X 100 = 1000 only. Because the Call Option price can not fall below 0.

Applications of Short Selling

Seasoned and professional traders or investors use short selling in many ways. The most important out of it is the protection of long term portfolios held by long term investors.

Portfolio Hedging

Big investors who are holding large portfolios of the stocks use short selling to hedge their portfolios from market downside. If they anticipate any major down move in the markets, say 10-20%, they short sell to prevent their portfolio erosion.

They make money from short selling of stocks and compensate for the losses incurred to their long term portfolios with the stock market falls.

It is not easy for them to keep offloading their stocks before every fall in the market and again buy them when environment is cheerful.

They need to keep their holdings to earn the dividends from the respective companies, to remain eligible to receive the bonuses or bonus shares otherwise the very purpose of their investment gets diluted.

They calculate the portfolio for each stock and short sell the equivalent quantity of that stock in either futures or options route. In case the markets fall and the portfolio erodes, they earn equivalently on their short position.They can keep this profit with them or add more quantity of that stock with this profit.

In Nutshell, they almost loose nothing or minimal. This is done only when the expected fall is significant and not for routine corrections in the markets.

Speculative Trading

Speculator traders short sell to ride the market move on downside. It adds versatility to their trading business.

They keep on spotting the opportunities. When markets go up, they take long positions. When market starts falling, they go for short selling of stocks.

To keep your short position alive in the market for short term, you can opt for shorting futures or buying put options.

Intraday traders can go for short selling with margin trading. Buying put options is a low risk high return strategy. Buying options keeps your risk limited and returns unlimited.