Short Selling: Concept Simplied

Stock market crash is not a daily occurrence but whenever it happens, it is mostly severe and can erode investors’ wealth. Most people fear investing or trading due to the possibility of a crash. This year, the Coronavirus pandemic and the fears of an economic recession, led to a severe crash in the stock markets worldwide. Many of my well-wishers who knew about the recent change in my profession were often skeptical that I am losing heavily in the stock markets because of the crash. Well, I did make some money during the crash. In this blog, I will explain the concept of short selling which enables you to sell today and buy later thereby making a profit in a falling market.

Let’s first understand the difference between buying a stock and short selling a stock.

BUYING A STOCK: Imagine a situation where you are a customer who wants to buy a biscuit. You take sufficient cash to a grocery store, look at the types of biscuits available, select the biscuit best suited to your taste and preference, pay the price and buy the product. Similarly, when you want to buy a share, you go to your broker in the share market with cash to buy the selected stock at its current market price. The first difference between buying a biscuit and a stock is, a share is in an electronic form or dematerialised (demat) form while a biscuit is in a physical form. The second difference is that when you buy a share you become part owner of the company i.e. you become an investor instead of a customer. Buying a stock is profitable when the share price rises above your buying price +transaction costs.

SHORT SELLING A STOCK: Understanding short selling is not as straightforward as buying a stock. In the previous example, imagine you are the shop keeper instead of the customer. You need to keep a variety of biscuits in your shop. Instead of buying the products in bulk, you go to a wholesaler and get the goods on credit. You display it in your shop and sell to a willing customer. Now, you collect cash from the customer and pay the wholesaler. Effectively, you have sold first and then bought the goods. Also, this transaction would be profitable only if your selling price is more than your costs (where costs are buying price+ transportation cost + storage costs). Similarly, when you borrow shares from your broker and first sell the stock at a higher price and then buy it after the share price falls (i.e. at a lower price), you have done a profitable short sell. Since you are first borrowing the shares from your broker, you will have to give an initial margin (it’s like a security deposit given to your broker). The additional costs in a short sell are brokerage and taxes. NOTE: you will make a profit in a short sell only in a falling market. In other words, you can make money even in a falling market using short sell!

WHEN TO SHORT SELL? When you expect stock price to drop. You need not wait for a stock market crash! Short selling can be used when you feel a stock is overvalued, during downturns in a cyclical industry, when technical indicators show a short-term short selling opportunity, and of course when the overall economic indicators are weak leading to a stock market crash.

DIFFERENT INSTRUMENTS AVAILABLE FOR SHORT SELLING

Scenario 1: You expect the price to fall

Instrument	Buy/Sell	When to use?
Cash	Sell	You can sell in cash market only if you already own the shares. In case you own the shares, you are also allowed to sell your shares on an intraday basis (within trading hours) and close your position on the same day without giving delivery of your share. Quick fact: Intraday trading in cash segment comes under business income for tax purposes.
Futures	Sell	When you are bearish in the market, you can use this instrument. You gain when the price falls and lose when the price goes up. Note 1: Not all shares have futures. Index futures are also available in India. List of F&O stocks & index can be obtained here. Note 2: This is a leverage instrument which means only part of the underlying stock’s value needs to be paid as a margin for using the instrument. Note 3: There is a minimum lot size determined by the exchange for each stock future. You can only buy/sell in multiples of the lot size. This implies that the minimum investment for futures is higher than in the cash segment.
Call option	Sell	Options come in different strike prices which can be thought of as price levels. One generally sells the call option at a strike price above which they do not expect the stock to go before the expiry date (for stocks, expiry is the last Thursday of the month and for index, it is every Thursday). Note 1: Simply put, premium is the price at which call option was trading when you sold it.  The premium collected when you sell the call option is the profit if stock expires below your strike price. Note 2: Option selling generally requires similar margin as future selling. However, in case the price at expiry is above your strike price then you will have to give delivery of the underlying securities which is generally 4 times your margin requirement. Note 3: Note 1, 2 and 3 from futures are applicable to options as well. Quick Fact: Margin requirement for short selling options two days before expiry is higher than at the start of the month.
Put option	Buy	This option is most common with investors who want to protect their downside risk when they are investing. Put options can be thought of similar to buying an insurance. The price you pay is the premium for the insurance against the downside risk. Note 1: The margin required in buying options is much less than selling options. Note 2: This option is profitable as a hedging instrument. However, for this instrument to be profitable in a trading scenario, the price of the stock must fall rapidly. This instrument will lead to losses in case the stock is in an uptrend or it is sideways. Note 3: Note 1, 2 and 3 from futures are applicable to options as well.

Scenario 2: You expect the price to increase

Although short selling is generally done when the price is expected to fall, there is an instrument which can be shorted when you expect the price to increase. This instrument is the put option. As explained above, buying a put option means you expect the price to decrease. Hence, when you sell that instrument, you expect the price to go up. The premium you collect for giving insurance to the put buyers is your profit if the price closes above your strike price. However, in case the price falls below the strike price, you will have to take delivery of the underlying stock at the strike price.

 

Futures and options is a course in itself and people do fascinating things by using combinations of the above described instruments. I have tried to explain the basics of the instruments in this blog. In case you have questions or suggestions, please post in the comments, I will try to clarify.

 

Explanation of key finance terminologies used in this blog can be found here.