Short Selling A Stock: What it is and How it Works.
The Mechanics Behind Short Selling
Everyone knows what to do when they think the price of a stock will go up sometime in the future, you go to your brokerage portal and buy the stock hoping to sell it at a higher price in the future and make money. This is the philosophy behind value investing. But what if you feel that the stock price of a company is going to go down in the future? Is there a way in which you can potentially make money from this feeling?
Short Selling
Yes, there is a way in which you can make money out of a falling stock. The method is short selling. In short selling, an individual first sells a stock at price ₹X and hopes to buy it back later at a price less than ₹X, say ₹X-2 (exactly opposite to the usual buy first and sell later mechanism). This way, the individual makes ₹X by selling the stock and pays ₹X-2 while buying the same stock at a later time and hence keeps the ₹2 as profit. But how can you sell a stock/share which you don’t even own?
This is where your fellow investing community and brokers come in to play. Let’s say you want to short sell Yes Bank because you think it’s price will go down in the future. But you don’t own Yes Bank and hence can’t sell it from your account. So, you request your broker to lend you a share of Yes Bank so that you can sell it in the market. Your broker probably has millions of clients out which some of them own Yes Bank shares. These shares are kept in the broker’s inventory. Because these shares are not doing much sitting in the inventory, the broker decides to lend you these shares at a small interest rate.
Now, you have the share and decide to sell it in the market at the current market price, say ₹30. This opens up 2 possibilities:
- The share price goes down: As you had expected, the share price fell to a lower level, say ₹27. You then buy back the share at this price and pocket the ₹3. Your business with the Yes Bank share is now done and hence, you decide to give it back to your broker.
- The share price goes up: Contrary to your expectation, Yes Bank’s share price went up to say ₹34. You sold the share at ₹30 and hence have this amount in your account. You now have to buy the share back at ₹34 but what if you don’t have these extra ₹4 in your account? You then can’t buy the share back and return it to your broker who might have to return the share back to his other client, who further might want to sell the share. The broker now has no way to return the share to his other client. So, in order to protect himself from these situations, the broker forces you to keep some amount in your account as a ‘margin’ before he lends you the share. In this case, the margin might be around ₹5. So, after you sell at ₹30, you have a total of ₹35 in your account and can hence buy the share back at ₹4 and return it to the broker. You would lose ₹4 in this scenario.
Note: You might be wondering what happens if the price goes beyond ₹35 in the above case. You won’t be able to buy it back despite the ‘margin’ you kept in your account. In such cases, the broker buys back the share himself at ₹35 on your behalf and keeps it with him. The broker usually gives you a notification when the price is around ₹34 asking you to add more money into your account in order to account for further price increases. But if you fail to do so and the price hits ₹35, the broker sells the share himself.
You don’t have to directly ask the broker to lend you a share. If you click on ‘sell’ in your trading terminal without owning the share, the terminal automatically recognizes that you want to short sell and places a request to the broker to lend you a share. This request is usually fulfilled immediately by the broker and you can sell the share.
But if you click on ‘sell’ while you already own the share, the terminal will treat it as if you just want to exit a long position i.e sell a stock you already own, so no request is placed to the broker to lend you a share.
For how long can you borrow a share?
In India, you can borrow a share for one day at max. Irrespective of whether you buy the share back or not, the broker will automatically buy the share back on your behalf at around 3:20 pm before the market closes for the day. But why?
In India, we follow a T+2 settlement cycle. In simple terms, if you sell a share on day T, you are required to have that share in your account after trading closes on day T so that the exchange can transfer the share to the buyer.
When you sell any share, the stock exchange is notified saying you have sold a share but the exchange doesn’t know whether you’ve sold a share you own or you’ve sold a share you have borrowed. It can find this out only at the end of the day when it searches for the share in your account in order to transfer it to the person who bought it from you. If you have sold a share you own then there is no problem as the exchange will take it from your account at the end of the day and transfer it to the buyer. But, if you have short sold a share, you don’t have the share in your account and hence the exchange can’t find the share in your account at the end of the day and will hence impose a heavy penalty on you.
In order to avoid this penalty, you are required to buy the share back before trade closes on the same day as you sold the share. When this happens, the share is now in your account after trading closes and the exchange can make the required settlements after which you can return the share to your broker.
Who benefits from loaning you the share?
Even though share you borrowed is owned by some person, he/she won’t make any money by lending it to you. The broker makes the money because he is the one who facilitated this lending-borrowing business.
This is risky for the broker because once you borrow the share, there is no guarantee that you will return it back to him because you might not have any money to buy the share back. To compensate for this risk, the broker usually charges 2 types of fees from you:
- Interest: The broker charges an interest rate on the share you have borrowed. This is to be paid irrespective of whether you make money on the trade or now. This is usually a percentage (say 0.05%) on the total value of the shares borrowed at the time of borrowing.
- Commission: The broker also charges a commission on your returns. This is to be paid only if you make money from the trade. This is usually a percentage (say 0.1%) of your returns.
Does short selling benefit markets as a whole?
Definitely yes. Short selling benefits the market in the following ways:
- Provides liquidity to the market
- Allows people to make money even in bearish phases
- Facilitates price correction of overvalued stocks
What if you want to short for more than 1 day?
If you want to hold a negative position on a publicly-traded company for more than a day, you will have to use futures or options to do so. It is not possible to do so using equities, at least not in India. More on this later.
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