What Is Short Selling In the Stock Market?

Have you ever sold something which you don’t own? It may sound crazy at first, but it is possible to sell shares in the market you don’t own and thereby make money. Such an investment strategy is called short-selling.

This article discusses what short-selling in the stock market is, metrics for short-selling, an example of short-selling, its advantages and disadvantages, and more.

What Is Short Selling In the Stock Market?

Short-selling is an investment strategy aimed to profit from the downgoing stock price. Let’s understand how to short-sell a stock with the step-by-step process.

Firstly, if the trader expects the stock price to go down in the future, he would borrow shares from the broker to sell them at a higher price. Then, he waits for the stock price to go down. Once the stock price goes down, he purchases the shares and gives them back to the broker. Thus, he benefits by buying low and selling higher.

Short-selling is characterised by stock price speculation, leverage, margin maintenance, etc.

What Are The Metrics For Short-Selling?

Traders mainly use the following two metrics to understand short-selling activity in a stock.

1. Days-to-cover ratio

The days-to-cover ratio primarily tells the average number of days it takes short sellers to cover their positions, i.e., repurchase all borrowed shares. It is also known as the short-interest-to-volume ratio and is calculated by the following formula. 

Days-to-cover = Number of shares sold short / Average daily trading volume

A higher days-to-cover ratio suggests that it will take longer for short sellers to close their positions if the stock price suddenly rises, and vice versa. Therefore, lower days-to-cover indicates optimistic sentiments about the stock and vice versa.

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2. Short interest ratio

The short-interest ratio represents the relationship between the number of shares currently shorted and the number of shares floating in the market. A higher short-interest ratio means more shares are shorted, indicating that the stock price is likely to fall. 

However, a higher short interest ratio also increases the probability of a short squeeze, i.e. short sellers need to close out their positions by buying stocks at higher prices.

Short-Selling: Profitable For Loss

Traditional stock market strategies aim to buy stocks and sell them later at a higher price. If the stock prices decline in future, investors may incur losses or get lower returns from investments. However, short-selling is different. Here, investors first sell stocks at a higher price, then buy them at lower prices and pocket the profits.

Example Of Short-Selling

Here is a short-selling example.

Nirmit speculates that the XYZ stock will fall from the current market price of ₹250 in 10 days post the disclosure of its quarterly financial reports. Assuming that, he borrows 50 shares and sells them in the market at the current price of ₹250. After that, two scenarios can happen:

Scenario 1

After ten days, as he speculates, the stock price begins to fall and drops to ₹200. He then repurchases 50 shares at ₹200 and returns them to the broker. Thus, theoretically, he makes a profit of ₹2,500 (50 shares * ₹50 profit each). However, he might have paid the broker the interest on borrowed shares and commissions.

Scenario 2

After ten days, the stock price rises and reaches ₹280 because the company gets acquired by a big company. To close his position, he needed to buy 50 shares at ₹280. Thus, he incurs a loss of ₹1,500 in addition to interest on borrowed shares and commissions.

Short-selling In India

In India, both retail and institutional investors are allowed to short-sell shares. However, there are specific rules for short-selling in India.

• Naked short-selling is not permitted in India. Naked short-selling is a practice where the short-seller enters into a contract to sell without borrowing shares or even inquiring whether such shares can be borrowed.
• Institutional investors cannot engage in day trading, i.e. squaring off their short-selling transaction within the same day.
• Before the start of trading on the following trading day, the brokers have to collect information on scrip-wise short-sell positions, compile the data, and upload it to stock exchanges.

Advantages Of Short-Selling

• Traders will enjoy higher profits if their speculation comes out right.
• Leverage is another important benefit of short-selling. Traders engaged in short-selling borrow shares from the broker and need to put up a little capital initially to profit significantly in future.
• The strategy may also help to hedge against the downside risks of investments and thus may help to protect the investor’s portfolio.

Disadvantages Of Short-Selling

• One of the biggest problems with short-selling is the probability of infinite loss, even more than 100% of the investments, since there is no certainty about how much upward the stock price can go.
• Costs of short-selling are another point of concern. The interest payable to the broker on borrowed shares, dividend payments, commission, etc., are some of the short-selling costs. 
• Traders need to maintain the margin (the amount the trader needs to deposit to the borrower to cover credit risk). They may need to liquidate their positions if they fail to do so due to market fluctuations or other reasons.
• If more shares of a stock are shorted, and the stock price goes up, short-sellers may need to close their positions by repurchasing shares at the higher price, which may further drive up the stock price, resulting in a short squeeze loop.

Final Thoughts

Short-selling offers the stock market liquidity and efficiency. However, short-selling requires experience and expertise, and therefore, newbie investors with limited knowledge of the stock market dynamics may not find this strategy suitable.

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