When hearing or reading terms like ‘short selling’, ‘going short’ or ‘shorting’, those who are not very familiar with the stock market will wonder what they mean.
Short selling in stock market means selling stocks which you do not own. You can sell the stocks first and buy them later. Strange, isn’t it? We can surely sell what we have be it a house, furniture or stocks. How can we sell what we do not have? Well, this is possible not only in stock markets but also in commodity markets and currency markets. By providing the option of short selling, these markets allow traders to bet not only on prices going up but also on price falls.
Short Selling in The Stock Market Can Be Done in 2 Ways:
Short Selling in the Cash Market:
Day traders usually go short in the cash market. This means that a trader can sell scrip which he does not own provided he buys it back before the close of the day’s trade. If he gets to buy at a price lower than the selling price he will make a profit. Even if the price of the scrip shoots up he will still have to buy it at a loss since he has sold shares which he does not own.
If there is a major upward move in the price of the stock, the stock may get locked in upper circuit at which price there are no sellers at all. In such an event, the short seller will not get an opportunity to buy back the shares. Or he may postpone the buying to the last minute and technical glitches or power outage may prevent him from purchasing the shares.
In case he fails to buy the shares before the markets close for the day, the stock exchange will buy back his shares in the auction at a high rate and the trader will have to bear the cost. Sometimes a penalty is also imposed by the exchange. So the trader may run a huge loss if a short sale goes wrong. It is always advisable to place strict stop losses so that one can restrict one’s loss if the stock price does not fall as anticipated.
Short selling in the cash market is usually done by small traders who cannot afford to take positions in the futures market where the lot sizes are huge.
Short Selling in The Futures Market:
Professional traders generally go short in the futures market. Shorting in the cash market allows only a few hours to the trader to cover his short positions. But a trader may expect the price to fall the next day or in a few days. Futures markets allow traders to take a positional call on the downward price movement of shares.
In the cash market one can go short only on individual scrip and not the stock market indices like the Nifty. Futures traders have an advantage in that they can go short on the index futures when they expect markets to go down. Even traders who are bearish for the long term can go short in the futures market and keep ‘rolling over’ their positions till they feel that it is a good time to close the short position.
‘Badla’ – The old Avatar of Short Selling in India:
Before the introduction of futures trading, there was a system called ‘badla’ wherein a trader could go short in the cash market and hold this short position till the end of the trading week i.e. Friday. The drawback was that it was not very organized resulting in traders and brokers misusing it. So this system was abolished and the current system was established.
In the absence of short selling, people could profit only from upward price movements. Short selling brings in balance in the stock market.