The logic behind making profit is easy peasy; even a Class III student can crack the code in the wink of an eye. Buy a product/service at a low price first and then sell it at a higher price – pocket the difference amount as profit, not a nuclear physics...
In any normal trade, for selling a product/service, the seller must either own the product first, or at least, have the possession of the product. For instance, if a jeweller wants to sell gold jewellery or gold coin, he should be the owner of it or he must have the authorisation to sell it at an authorised showroom. If you don’t have it ready-made in the showroom, you must have the authority to arrange delivery through manufacturers/owners. Even if you want to sell a used car or a bike or a mobile phone, you should own them. You can sell only your house and not someone else’s house. This is the mantra for sales and profit/loss in any trade, in which the first leg of the trade would only be a ‘buy’ transaction and the second leg would be a ‘sell’ transaction.
In contrast, the short selling strategy is entirely a different ball game. Here, the first leg of the transaction would always be a ‘sell’ transaction and the ‘buy’ trade will happen only in the second leg. So, how do you make profit? You first sell at a higher price (first leg) and then buy at a lower price (second leg). The highlight here is that it is immaterial whether you own or possess the product in the first place. The short selling strategy, popularly known as shorting, in the stock market parlance, might be quite puzzling or surprising for those who are new to the world of bourse. This is because, the strategy of selling first and buying later, is very much contradictory to the traditional ways of making profit in any trade.
Perhaps, in the entire world of trades, short selling is possible only in the equity markets and not in any other type of market/trade, at least as far as I know. That is, shorting is the only strategy wherein you can sell first without having an ownership or a possession. Wondering if it’s legal or illegal? Of course, very much legal and approved by the Securities and Exchange Board of India (SEBI), the markets watchdog of India.
Now that we know that short selling is possible only in stock markets, it’s a no-brainer to guess that shorting could be me made only for stocks. So, if you want to make profit, you must sell a stock first at a higher price, even if you do not have it in your Demat account and then buy later at a lower price. Why the name shorting? It’s because you are short of stocks. Still, for the sake of making profit, you are selling them, that’s why ‘short selling’ or ‘shorting’.
You must note that selling a stock and shorting a stock are not one and the same. Imagine you have already purchased a stock and hold/possess it in your demat account. In the same day, or after a week or a month or even after several years, you sell it to make profit. So, here, the first leg of the trade was only a ‘buy’ transaction which happened on the same day (intraday) or before several days, months or years (delivery). The ‘sell’ transaction was made only in the second leg of the trade, so you are not short of the stocks and so this is not shorting or short selling of stocks but normal selling of stocks.
In contrast to shorting, while selling you are only squaring off the existing long position [going long means buying] of the share, which you have already bought and hold it in the demat account. Whereas, in shorting, you are selling a stock first, even without owning it in your demat account, in the first place. ‘Square-off’ is a trading jargon which means closing an existing position (either long or short) by doing an exact opposite trade of the first leg. That is, if you have purchased a stock first (long), you would square-off by selling it later; and if you have sold first (shorting), you would square-off by buying it later.
Let’s see how shorting, that is selling a stock without having it in your demat account, would be possible practically. In shorting, you are borrowing the stock from your broker, and this implies that you have a definite obligation to return it to the broker within the stipulated time.
Types of short selling
Basically, shorting is of one type only – sell first and buy later. However, you could do short selling in two types of markets – spot market and futures market. The short-selling strategy, in both the markets, is one and the same but the difference lies in the time allowed for squaring off.
In spot market, which is otherwise known as cash market or cash segment, shorting is allowed only for intraday trading (just one day.) That is, all spot market shorting square-offs must be made before the market closes for the day at 3.30 p.m. You cannot carry forward the shorted stock as a delivery stock for a long time, not even to the second day. It must be bought back on the same day to square off, and it is immaterial whether you are making loss or profit in the deal.
However, in the futures market, you have the liberty to roll over the shorting trade to the future date and it is not compulsory to square-off on the same day.
When can you short sell?
You can short a stock only if you are confident that the price of the stock will fall for sure. You will book profit only if your prediction is correct and the stock goes down as expected. If not, you will burn your fingers.
For instance, let’s assume that I shorted a stock of a company named ‘Dinosaur’ and I do not have the stock in my demat account. That is, at first, I sold the stock at ₹3,240 at 9.30 a.m., expecting that the price would hit Rs.3,000 on the same day. As expected, if the stock price fell to ₹3,000, I would buy the stock before the market closes for the day to square off my earlier short position and make a profit of ₹240.
Unfortunately, if my prediction goes wrong and the price increased to ₹3,480, I will incur a loss of ₹240 as I must buy at Rs.3,480 to return it to the broker. This is because, in the spot market, whether you have shorted/sold a stock, you must ensure that the stock is delivered to the exchange within the stipulated time, that is before the market closes for the day. You cannot avoid squaring-off to avoid loss-making trades. If you avoid squaring-off, you must pay a hefty penalty for the ‘Short Delivery.’
If the ‘short delivery’ situation arises, the exchanges would settle the delivery process of the short stock via an auction market, which are costly. Further, if your stock is illiquid and there are no sellers for you to buy before the market closes, you will pay paying hefty penalties. It is for these reasons that shorting might be risky, especially for budding traders.
Let’s look at the futures market. Agreed, you need not square-off your short position on the same day and can roll over the position. But, for this, you must deposit a margin amount which is costly and not affordable for retail traders. Theoretically, shorting might seem easy and might seem the best bet for making profit, it might lure you, but it’s not the case in majority of the trades in reality.
Stay away from short selling. No short-cuts or quick ways to make profits. Let’s discuss another interesting and informative episode soon. Until then…