The long & short of ‘Short Selling’ – By Prof. Simply Simple Short selling is neither terribly complex nor entirely simple. In other words, it's a concept that many investors have trouble understanding. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.

Therefore… In finance, short selling or "shorting" is the practice of selling securities the seller does not own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond. This is in contrast to the ordinary investment practice, where an investor "goes long“ i.e. purchasing a security in the hope the price will rise.

The act of buying back the shares which were sold short is called 'covering the short'.

How does it work? A short seller, say Ram, sells a stock that he believes will fall in value. Now, Ram does not own the stock before he sells it. Instead, he borrows it from someone who already owns it, say Shyam. Later, Ram buys back the stock he shorted and returns the stock to Shyam to close out the loan. If the stock has fallen in price since he sold short, he can buy the stock back for less than he received for selling it. The difference is his profit. But, Ram would need to honour the obligation of delivering the stock at the time of settlement.

But, why would anyone sell short? The two primary reasons for selling short are: Opportunism and Portfolio Protection. Occasionally, investors see a stock that they believe has been hyped to a ridiculously high level. They believe that the stock price will fall when reality replaces the hype. A short sale provides the opportunity to profit from the overpriced stock.

Also… Short sales are also used to protect an investor's portfolio against a market downturn. By shorting stocks that the investor believes will fall sharply when the market as a whole falls, investors can help insulate the value of their portfolios against sudden market drops. By shorting carefully selected stocks that are priced near their peak but that will fall sharply if the market falls, an investor can use the profits from the short sales to help offset losses in his long position to protect the value of his portfolio.

To give you an example… Assume that shares in ABC Company sell for Rs. 10 per share in August. A short seller would borrow 100 shares of ABC Company, and then immediately sell those shares for a total of Rs If the price of ABC shares falls to Rs. 8 per share in September, the short seller would then buy 100 shares back for Rs. 800, return the shares to their original owner (paying a fee for having borrowed the shares) and make a Rs. 200 profit (minus the fee for having borrowed the shares).

So, are there no risks to this? This practice has the potential for losses as well. For example, if the shares of ABC that one borrowed and sold in fact went up to Rs. 25 in September, the short seller would have to buy back all the shares at Rs. 2500, losing Rs Because a short is the opposite of a long (normal) transaction, everything is the mirror opposite compared to the typical trade: the profit is limited but the loss is unlimited.

To Sum Up The proponents of short-selling view the practice as a desirable and essential feature of a securities market. They argue that in a weak market, short- covering of positions taken at the beginning of a downturn, would arrest the declining trend. Critics of short-selling, on the other hand, are convinced that short-selling poses potential risks and can easily destabilize the market directly or indirectly.

Hope you have now understood the concept of Short Selling In case of any query, please