What is Short Selling in the Share Market?

Key Takeaways

• Short selling involves selling stocks at a higher price and buying at a lower price.
• In India, retail investors are allowed to short-sell on an intraday basis in the cash market.
• A short-selling strategy works better in a bearish market phase.
• Short selling in futures and options is different from short selling in the cash segment.

Introduction to Short Selling

In India, short selling is widely used by institutional investors in intraday trading as well as in futures and options trading for both speculation and hedging. Whether you’re trading on NSE or BSE, understanding the concept of short selling can improve your trading strategy, especially during bearish market conditions.

This article aims to explain short selling in the share market cash segment and the derivatives segment, along with its benefits and associated risks.

Short Selling in the Share Market

Short selling in the share market is a strategy in which a trader sells shares first and buys them later to earn profit from falling prices.

But, if a trader doesn’t own those shares, how can they sell them?

In this process, a trader with a bearish view borrows shares from a broker and sells them immediately at the prevailing market price. While trading in the cash segment, short selling is possible only intraday. Traders need to square off their positions and return the borrowed shares to the broker before the end of the trading session.

Also, in short selling, you need to maintain margin money in the account. This is a security amount blocked with the broker for safety purposes.

How Does Short Selling Work?

Short selling works differently in the cash segment compared to the derivatives segment.

Let us first understand the concept of short selling in the cash segment. The entire process can be explained in four simple steps:

• You sell the shares at a higher price, after borrowing them from the broker.
• If the price falls, you buy them back at a lower price, and the difference is your profit.
• If the price rises, you buy them back at a higher price, and the difference is your loss.
• When you close the trades, the borrowed shares are automatically returned to the broker.

What happens when a trader does not square off the short-selling trade?

On the NSE and BSE, short selling in the cash segment is allowed only on an intraday basis. That means, you must square off (close) the position on the same day, before the market closes. If not squared off, brokers may auto-square off, and the trader has to pay the penalty.

Unlike global markets, positional short selling in equities is restricted in India, unless done through derivatives.

Example of Short Selling in the Cash Market:

• Suppose the stock X is trading at ₹1000. (Note: You don’t own shares of stock X in a demat account)
• You expect the price of stock X to fall to ₹950.
• You sold 10 shares of stock X at ₹1000.
• Price falls to ₹950, profit is ₹1000 - ₹950 = ₹50 per share.
• Total profit = 10 (shares) x ₹50 = ₹500.

However, if the stock X rises to ₹1050, you would have made a loss. Calculation of loss: ₹1000 - ₹1050 = (-50) per share. Total loss = 10 (shares) x 50 = ₹500.

Short Selling in Futures

Short selling in futures is one of the easiest ways to take a bearish position in the share market. While trading in futures, you can carry forward your short-selling trade till expiry.

How does it work?

• You sell a futures contract without owning the underlying asset.
• If the price of the underlying falls, future contracts follow the same.
• If the price rises, the price of futures will also rise.

Therefore, in futures short selling, if the price of futures contracts falls, you make a profit. If the price rises, you make a loss.

Example: Short Selling in Futures

• Suppose: A Nifty futures contract is trading at 24,000.
• Nifty 1 lot = 65 shares
• You expect the Nifty price to fall to 23,800.

So, you decide to sell 1 lot of Nifty futures at 24,000. If the price of Nifty falls to 23800, you will make a profit of 24000 - 23800 = 200 points.

Total profit = 200 x 65 (1 lot) = ₹

On the other hand, if the Nifty futures price rises to 24, 200. You will lose 200 points (24200 - 24000), which is equal to -200 x 65 (1 lot) = ₹-13000.

Advantages of Short Selling in Futures

• No restriction like intraday trading
• High leverage available.
• Ideal for taking bearish trades in a downward market trend.

Short Selling in Options

Short selling in options is different from short selling in stocks or futures. Here you will sell call or put option contracts.

Short selling in options is divided into two parts: short call options and short put options.

Short Call Option:

• You sell a call option when the market view is bearish and expect the underlying asset price to remain below the strike price.

• The option premium price will fall, and you earn a premium.

Short Put Option:

• You sell a put option when the market view is bullish and expect the underlying asset price to remain above the strike price.

• Here also, the option premium price will fall, and you earn a premium.

In both scenarios, you expect the option premium to fall.

Example of short selling in a call option:

• Nifty CMP 23900.
• Nifty 24000 CE trading at 50.
• Nifty 1 lot = 65 shares

You sell a nifty 24000 CE, expecting that the nifty will not cross the 24000 market till expiry. If the Nifty price remains below 24000, you earn a premium of ₹50.

Therefore, total profit is 50 x 65 (1 lot) = ₹3,250.

How is Short Selling Different From Normal Investing?

In short selling, you sell a stock at a higher price (that you don’t own in your demat account), then buy back the stock at a lower price. While engaging in short selling, you need to keep a margin as a deposit, and this process is allowed only on an intraday basis.

In contrast, in normal investing, you buy a stock first at a lower price, then sell it at a higher price to earn a profit. In this case, you need to pay the full amount to buy the shares.

In regular investing, you can hold the shares beyond the intraday and take delivery. The next day, after settlement, the shares bought will be credited to your demat account.

Benefits of Short Selling in the Share Market

Short selling in the share market offers several advantages for traders and investors.

• Profit in Falling Markets

In short selling, you can earn profits in the bearish market phase.

• Hedging Strategy

Short selling helps to hedge the risk in long-term investments and reduce the portfolio losses.

• Use of Leverage

Traders can take bigger positions with less capital due to high leverage. This is possible, especially in futures.

• Income from Option Selling

Option sellers can sell OTM (Out-of-the-money) call or put option earn premium income.

Risks Involved in Short Selling

Short selling also carries certain risks:

• Unlimited Loss Potential

When buying stocks, the maximum loss is limited. However, in short selling, losses can be unlimited. Example: If the stock rises from 1000 to 1500, your loss keeps on increasing. Similarly, in futures and options, the loss can be unlimited.

• Short Squeeze

A sudden rise in stock prices might force short sellers to cover their positions quickly, leading to a chain reaction and further price increases.

• Margin Requirements

Short selling requires margin, especially in futures and options. If the margin falls below the required level, brokers may forcibly square off the positions.

• Timing Risk

Markets can remain irrational for longer than expected. Prices may continue to rise even if fundamentals are weak.

• Volatility Risk

High volatility can trigger stop loss orders, especially in derivatives trading.

SEBI’s Short Selling Framework

The Securities and Exchange Board of India (SEBI) regulates short-selling activities in India. It ensures transparency and risk control.

• Both retail investors and institutional investors are allowed to participate in short selling.
• Naked short selling (selling without borrowing the stock) is not permitted.
• Institutional investors are not allowed in intraday square off; they must settle obligations on a gross basis at the custodian level.
• While engaging in stocks in the cash segment, retail investors have to square off positions on an intraday basis.