Short selling

Short selling is an investment that speculates on the decline in a stock or other security’s pricing. It can be undertaken by experienced traders and investors.

In a short sale, a trader borrows shares from the owner with the help of a brokerage and sells it at market price with the hope that prices will fall. When prices drop, the short seller buys the shares and books a profit. To know what is short selling, it is necessary to understand that it is practised by seasoned traders and investors and is based on speculation that the price of shares will drop before they are returned to the owner. Short selling has a high risk to reward ratio as it is capable of earning profit as well as incurring huge losses.

There is a possibility of high profits, but potential unlimited losses. A short-seller may find it difficult to find enough shares to buy when it is time to close a position. Regulators may impose ban on short sales in some sectors to avoid panic and unwarranted selling pressure. Short selling has a bad reputation due to unethical speculators. Many brokers allow short selling in individual accounts, but after applying first for a margin account.

In the stock market, a short sale is made to earn profits in a short period. Some believe it is similar to owning stocks for a more extended period. Long-term investors buy stocks hoping for a price rise in the future, while short-sellers gauge the price situation and profit from the fall in prices.

Market manipulators often resort to illegal use of the short-selling method to deflate the prices of stock. This increases volatility and poses a significant risk to markets that can be destabilised. The deliberate reduction in stock prices can also impact the company’s confidence and reduce its fund-raising capability.

Risks of short sellin are;

Making a mistake in timing – The exercise of short selling depends on the proper timing of selling and buying of shares. Prices of the stock may not immediately decline, and while you wait to book profit, you are liable to pay margin and interest.

Borrowing money – Short selling means margin trading in which you borrow money from a brokerage firm using an asset as collateral. The brokerage firm makes it mandatory for you to maintain a certain percentage in the account. If you fall short of it at any point, you will be asked to meet the shortfall.

Choose wisely – Some companies go through bad phases but overcome them deftly. Wise administration can change the course of a company, increasing its share price instead of decreasing their value. If you choose the wrong company to bet on, you may lose in short selling when others gain by taking a long position.

Returning security – The seller must return the security to the owner within the stipulated period, failing which the seller will be subjected to scrutiny by the market regulator.

Regulations – Short selling, although permitted by market regulators, can face a ban in a particular sector any time to avoid panic. This can lead to a surge in prices.

Betting against the trend – Stock prices generally tend to move up in the long run. Short selling depends on prices moving down, which is going against the drift.