Short selling, also called shorting, is quite tricky for investors who are new to the bourses. 

For, the concept deviates from the much-established ways of making profit – first buy at a lower price (first leg of trade) and then sell at a higher price (second leg).

Further, in most cases, sellers either own the item or possess it. For instance, if you want to sell a car, a gadget or an apartment, you should own it first. 

Or, if a sales agent sells a car/bike/gadget, he possesses it in his showroom or arranges delivery through manufacturers. So, either ownership or possession is crucial, only then could a sale be made. 

Sell first, buy later

In contrast, in shorting, you carry out the trade in the exact opposite manner. 

You sell first and then buy later. Further, you need not own or possess the item at all. Confusing, right? Let’s see how this works out.

Shorting is possible in equity markets. Perhaps this might be the ‘only trade in the world’ where you can sell without ownership or possession.

Selling and shorting a stock are entirely different. Selling a stock you already have bought (it is available in your demat account) is not shorting, because you are just squaring off the existing long position. Whereas, if you sell a stock without owning them in your demat account, it is shorting. 

You are short of stocks, yet you are selling them, and that’s why the name — ‘shorting’ or ‘short selling’. 

Here, you are borrowing from the broker and you have an obligation to return it. Square-off means closing an existing position by doing an opposite trade of the first leg.

If you are long on a stock (bought a stock), you should sell later to square off. In contrast, if you are short on a stock (you sold first), then you should buy later to square off.

Types of shorting

There are two types of shorting — shorting in a spot market and shorting in a futures market.

The strategy is the same but the difference is in the time allowed for squaring off. In the spot market (cash segment), shorting is intraday, square-offs must be made on the same day, before the market closes at 3.30 p.m. 

You cannot carry forward the short trade for the second day. But, in the futures market, you can roll over the short trade without squaring off on the same day. Budding traders make profit in a bullish market. They buy stocks at a dip and sell when prices go up further. But seasoned traders make profit even in a bearish market. They sell the stocks first at a higher price, without having them in their demat accounts, and then buy them later at a lower price. 

The difference is the profit. You can short a trade only when you are sure that the stock price will go down. If your prediction is right, you will make a profit and if not, you will end up in loss.

For instance, let’s say RajV shorted a stock of ABYZ company at ₹2,100 in the belief the price would go down. As expected, if the stock price fell to ₹1,900, she would buy the stock on the same day to square off her short position and make a profit of ₹200. Unfortunately, if her prediction goes wrong and the price went up to ₹2,300, she would incur a loss of ₹200.

In the spot market, whether you have sold/shorted a stock, you have an obligation to ensure the delivery of the stock to the exchange before the end of the day. That is where the problem arises. In the above example, RajV cannot avoid the squaring-off trade to ensure she does not make a loss.

She must buy the shares for ₹2,300 and give delivery of the same. If not, she is defaulting against her obligation and hence, there would be a hefty penalty. This is known as ‘Short Delivery’ in the trading parlance. 

During the short delivery situation, exchanges would settle the delivery through the auction market. For retail investors or new traders, shorting is very risky. 

Huge penalties

Their price-fall prediction must be right and square-off must be made on the same day. If the stock is illiquid and you could not buy (if no sellers) before the market closes, you would end up paying hefty penalties.

In futures market, you need not square-off a short position on the same day but can hold on to the position overnight or roll over. But you must deposit a margin amount which is usually higher and not affordable for most retail traders and highly risky. 

Overall, it is always better for investors to stay away from shorting unless they have knowledge.

(The writer is an NISM & CRISIL-certified Wealth Manager)