Short Selling: Meaning, Benefits, Risk & Examples

In 2020, Yes Bank's stock was trading over ₹15, but experienced traders were vigilant to warning flags that indicated the bank was in trouble new bad loans, issues with governance, and apparent liquidity sheet issues. 

Eventually, the Reserve Bank of India (RBI) imposed a moratorium in March 2020, and the true financial state of Yes Bank came to light, and the stock price quickly fell below ₹10/share. Those who had identified the red flags early profited, in part, because they utilized short positions. 

However, short selling in India is rife with risk, must be done in compliance with SEBI regulations, and requires additional responsibility. 

This guide will explain what short selling means, how it functions in the Indian capital markets, and the risks beyond, and opportunities for profit or loss by presenting examples of both successful and failed bearish short selling and positions.

Quick Summary

An investor who borrows and sells stock they do not own in the hopes that its price will drop is engaging in short selling. They return it, buy it back at a reduced price, and keep the difference as profit if the price drops.

It boosts market liquidity and enables traders to profit from declining markets, but it also carries a high risk because there could be limitless losses if the price rises rather than falls. As a result, seasoned traders who are aware of the risks and complexity of short selling typically employ it.

Our Focus in the Article:

• What is Short Selling and How Does It Work 

• Discuss Short Selling Metrics 

• When is short selling Profitable 

• Short Selling Strategies for Beginners

What is Short Selling?

Short selling in India is a tactic utilized by an investor to borrow shares and then sell them in the market, anticipating a drop in the share price. 

Later, the investor will buy back the shares at a lower price, give them back to the lender, and keep the difference for a gain.

It is a method to generate profits when stock prices descend, with the highest risk associated with short selling being when the share price rises, thus leading to increased losses.

How Does Short Selling Work? (Step-by-Step)

A short sale is a trading technique in which investors gain profit when the stock price decreases. We will get this easily in a step-by-step illustration.

Step 1: Identifying an Overvalued Stock

You can use tools like Dhanarthi Stock Screener to identify potentially overvalued stocks through systematic filtering.

Step 2: Borrowing the Shares

You request your broker to short 100 shares of Company HDFC Bank.  These shares (of other clients or institutions) are found and borrowed by you through the broker. They are not yours, but you are borrowing them.

Important note:

In order to short sell, you need to have a margin account that will require you to hold at least a minimum balance as security.

Step 3: Selling the Borrowed Shares

You sell the 100 shares borrowed at once at the prevailing market rate of 1000 every share.  You get 100,000 rupees in cash, however, you will be paying your broker 100 shares in the future.

Your position right now:

Cash received: ₹1,00,000

Obligation: Pay back 100 shares to the broker.

Expectation: Price will drop

Step 4: Waiting for the Price to Drop

Eventually, you are right in your prediction. The company HDFC Bank records poor profits, and the share value goes down to 700 per share.

Step 5: Buying Back the Shares (Covering)

You are currently purchasing 100 shares at 700 a share. This costs you ₹70,000.

Step 6: Returning the Shares

You give back your 100 shares to your broker. Your shorts have been reversed.

Step 7: Calculating Your Profit

Money received from selling: ₹1,00,000

Money used to repurchase shares: 70,000.

Profit: ₹30,000  ( Including fees, brokerage fees, and interests)

Important Short Selling Indicators

When examining stocks, particularly if you're thinking about short selling or want to know how the market is feeling, three important indicators can help you determine the risks involved and how heavily a stock is being shorted. 

Let me give a brief explanation of each.

1. What is the Days-to-Cover Ratio?

The Days-to-Cover Ratio (also called "Short Ratio") tells you how many days it would take for all short sellers to buy back their shares and close their positions, based on the stock's average daily trading volume.

Think of it like this: Imagine 1,000 people borrowed bicycles and need to return them, but the rental shop only gets 100 bicycle returns per day. It would take 10 days for everyone to return their bicycles. That's your days-to-cover ratio of 10.

2. What is Short Interest Ratio?

The Short Interest Ratio indicates the proportion of a company's shares that are being shorted at the moment. 

It is determined by dividing the total number of shares that are available for trading (the float) by the number of shares that are sold short.

Let's say a bicycle rental business has 1,000 bikes for rent. 20% of the shop's bicycles are out on loan, as 200 of those bikes are currently borrowed and haven't been returned. Your short interest ratio is 20%.

3. What is short covering in stock market

Short covering in stock market is a practice that occurs in the stock market when traders who have shorted a stock cover their position by buying back the stock. 

When a trader shorts a stock, he first borrows shares of the stock, sells those shares in the market, and hopes the price of the stock declines before having to return the shares. 

Ultimately, he/she must return the borrowed shares, which means they must buy them back in the market first. 

Short covering occurs for two primary reasons

1. Profit Booking

When a trader shorts a stock and the price declines as he/she expected, he/she can repurchase the shares at a lower price to return to the lender, which creates the profit from the spread (the difference between buying back the stock at the lower price and the price at which he/she sold the stock short). 

2. Cutting Loss

A trader who shorts a stock may have an adverse price move in the stock, and therefore has to reduce losses quickly by buying back the shares, which creates forced buying of a potentially rapidly moving stock. This forced buying can exacerbate upward price pressure on that stock.

When Can Short Selling Make a Profit?

Stock is overpriced when there is a huge disparity between the value of the stock and the actual value of the company (earnings, assets, growth potential).

Simple analogy: When someone attempts to sell a used bicycle at ₹500, when they are similar to bicycles that sell at ₹100. The bicycle is overassessed fivefold.

How to Spot Overvaluation

These metrics are part of a comprehensive quantitative analysis that helps traders make informed decisions.

Very high Price-Earnings (P/E) Ratio:

Understanding P/E ratio in depth helps identify companies trading at unsustainable valuations. 

Compare these with price-to-book ratio and debt-to-equity ratio for comprehensive valuation analysis.

Example: A firm with a profit of 1/share, but with a share price of 100/share.

Unattainable Growth Expectancies:

Stock price presumes the growth of the company at 50 per cent annually indefinitely.

However, this is not possible because of the market size or competition.

Hype-Driven Prices:

• The price is pumped up by social media buzz or celebrity word.

• The valuation is not supported by the actual business.

Although short selling is dangerous and complex, you can start with the right strategies and steer clear of costly blunders if you're willing to learn. 

"Can I short sell in delivery?" is a question that many beginners have, and it demonstrates why getting the right advice is crucial.

You can lower risk during your learning process and gradually increase your confidence by being aware of the guidelines, timing, and beginner-friendly techniques.

Short Selling Strategies for Beginners

Short selling in India is not a safe and easy process, yet by being willing to learn it, you can develop the correct approach to it and prevent making expensive errors. I will describe low-risk methods that make the process of learning less risky.

• Learn the Basics of Short Selling
  Short selling involves borrowing stocks and selling them with the expectation that they will be repurchased later at a lower price, and a profit of the difference between the old price and the new price will be made. For beginners, it's essential to understand stock market trading tips for beginners before attempting short selling

• Select the Ideal Market Conditions
  Shorting is mostly done in bear markets or when the direction of the stock is downward. Monitor India VIX to gauge market volatility before initiating short positions.

• What is a short position in the stock market
  Selling a stock you don't own because you anticipate a decline in value with the intention of repurchasing it at a lower price is known as a short position in stock market. 

• Open a Short Position
  Borrow the stock through a margin account with your broker and sell the stock in the market. Ensure that the stock is available and can be borrowed using your trading platform.

• Set a Stop Loss to Limit Risks
  A stop-loss order should be a little above the resistance levels or the recent highs to avoid huge losses in case the price of the stock goes the other way. Stop-loss may be adjusted during the trade to gain profits or reduce losses.

Risk Involved in Short Selling

Short selling carries substantial financial risks as potential losses are theoretically unlimited since there's no cap on how high a stock price can rise.

Traders face additional dangers, including margin calls, forced buy-ins when shares become hard to borrow, and the risk of short squeezes, where rapid price increases force mass covering of positions at significant losses.

• Risk of Unlimited Losses
  When you short-sell, your losses can be unlimited because the stock price can rise infinitely. Unlike buying stocks, where losses are limited to the amount invested, here, if the price goes up, you must buy back at a higher price, losing more money as it rises.

• Risk of Short Squeeze
  A short squeeze happens when a heavily shorted stock suddenly rises in price. Short sellers then rush to buy back shares to cut losses, pushing the price even higher quickly. This can cause huge unexpected losses for short sellers.

• Margin Money & Interest Costs
  You borrow stocks to short sell, which requires margin money (deposit). You also pay interest or fees on borrowed shares. These costs can add up, especially if the position is held for a long time or if fees suddenly increase.

• Difficulty in Timing the Market
  Successfully short-selling needs precise timing, entering when prices are about to fall.

• Rules and Regulatory Risks
  Regulators may impose rules on short selling, like bans or restrictions, during volatile markets, which can trap short sellers unable to close positions.

Be aware of regulations like those governing insider trading, which can impact short-selling decisions

Advantages of Short Selling

Short selling in India enables investors to gain when the market and securities are falling, and so when conventional long-term positions would go against them to gain.

For those interested in derivatives as alternatives, learn about option Greeks and open interest to understand options-based hedging strategies

• Profit from Falling Prices
  You can only make money by selling the stocks when the prices decline, but when you simply purchase stocks, you can only make money when the prices increase.

• Hedging Your Portfolio
  It aids in hedging against your current investments to counter any losses that may be incurred in stocks that you hold. When others of your stocks decline, your short positions will be able to earn the losses.

• Leverage for Higher Returns
  Short selling typically entails borrowing of stocks, and therefore, you will only be paying a fraction of the value of the stock at the beginning (margin). This could be used to its advantage in case the trade works.

• Increase Market Liquidity
  Through short selling, you help to make the market have a lot of buying and selling, and this results in the easy trading of stocks without huge price gaps.

• Enhance Market Price efficiency
  The short sellers do aid in the correction of overpriced stocks by betting on the contrary, and this will help the companies to bring the stock prices nearer to their real price within a short period of time.

• Flexible Trading Strategy
  Short selling can be applied in a rising and falling market as the bigger picture of risk management and profit maximization.

• Potential for Quick Gains
  In unstable markets, the prices may drop fast, and short sellers are able to gain profits within a brief period of time.

Disadvantages of Short Selling

When you short-sell in India, you are taking on the risk of unlimited losses because a stock price could keep rising forever, and if you buy at the wrong time, you could lose more than you invested as the market confidently pushes the price higher. 

• Unlimited Loss Potential
  The worst part of short-selling is the risk of unlimited losses. Since stock prices can rise infinitely, if the price climbs instead of falling, you could lose much more than you invested.

• Interest and Margin Costs
  To short-sell, traders need to borrow shares. This not only requires margin money to borrow shares, but you will have to pay interest on the shares you borrowed. This can add up, particularly if you decide to keep the position open for a longer time frame.

• Short Squeeze Risk
  A sudden uptick in a stock that has a significant short position can trigger short sellers to buy back stock quickly, driving the price even higher. This can trigger more short sellers to buy stock, resulting in bigger losses for the crowded short-selling traders. 

• Market Timing Risk
  In order to short sell, there has to be perfect timing in entering the short sell position and exiting the position. If time is made on the wrong side of the market, traders will hold losing positions longer and incur more costs or experience volatility when prices reverse direction. 

• Difficulty in Borrowing Shares
  Sometimes shares are difficult to borrow due to traders wanting to short the same stock. This presents issues and increases the costs and difficulty of borrowing the shares to either open a position or maintain a position.

Short Selling vs Long Investing: Key Differences

Short selling and long investing represent opposite market strategies: short sellers profit from price declines by borrowing and selling shares they don't own, facing unlimited loss potential, while long investors profit from price appreciation by purchasing and holding shares with losses limited to their initial investment. 

Tax Rules for Short Selling

Short selling is a process of borrowing a security and selling it at current prices with the view of repurchasing it in the future at subsidized prices. 

In general, short sales are treated as capital gains or losses, and the holding period is based on the time you held the replacement property, not the period. 

• Short Selling is Handled as Business Revenue
  Profit or loss on short selling is not a capital gain in India, but it is a speculative business income. This implies that it is assessed at your normal rate of income tax slabs, and not on the capital gains tax basis.

• Tax Filing under Business Income
  Short selling is considered to be business income, and you have to list it under the name of business or profession under the income tax returns (ITR-3 form). 

• No Capital Gains Tax
  In contrast to the situation with normal equity trading, where the short-term capital gains (STCG) tax applies (typically at 15 or 20 percent), profits earned through short-selling are taxable at the full business rate, without a capital gain deduction.

• No Securities Transaction Tax/STT on the BOR/Lending
  Short selling of shares under the new scheme of SEBI does not attract STT or capital gains tax for the lending or borrowing of shares. The short sale transactions are, however, er taxable under business income.

• Tax Audit May Apply
  You might need to experience a tax audit in case your short-selling transactions are enormous and you choose not to be subjected to presumptive taxation, which raises compliance costs.

Short Selling Regulations (2025 Update)

Short-selling provisions in 2025 still need SEC compliance, such as locate requirements before selling, uptick rule exceptions, and increased reporting requirements to avoid manipulation of the market.

Investors are also forced to deal with margin requirements, pattern day trader regulation, and limits on short selling various securities under volatile market circumstances.

• None No Naked Short Selling
  Before short-selling, you have to borrow the shares. To prevent manipulation of the market and unfair deals, the selling of shares without borrowing money (the so-called naked short selling) is prohibited.

• Mandatory Short Positions Reporting
  Big short position holders are required to submit these positions every now and then to the stock exchanges. This assists regulators in monitoring large risk positions and cushioning the market against market jolts.

• During Volatile Markets - Restrictions
  In markets that have a lot of volatility or crashes, short selling can be temporarily prohibited or restricted by regulators so that panic selling is avoided and the markets are stabilized. These prohibitions tend to be temporary and reviewed regularly.

• Transparency in Borrowing Cost
  Before short selling is allowed, brokers should make it clear to the short sellers the cost of borrowing, the margin, and the interest rates. This makes investors know the total costs and risks.

Conclusion

One effective trading tactic that enables investors to make money when stock prices decline is short selling. In order to make money, shares are borrowed, sold at the current price, and then repurchased at a discount.

Although this strategy has the potential to be profitable, there are serious risks involved, including the possibility of limitless losses in the event of an unanticipated increase in the stock price. 

As a result, short selling calls for accurate timing, strong risk management, and a thorough understanding of market movements.

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