Short sell allows an investor or trader to borrow shares from other brokers or investors and sell them in the share market to buy it later on with decreased price to generate profit from the falling share price.
The short sell transaction allows the traders to trade on shares with the anticipation of falling share prices without even holding them. First the trader sells the shares at high prices and then buys the shares from the market at much lower price. The difference in sell and buy prices is taken as the profit from the transaction. Here the profit is generated from the falling prices and any share price rise leads to loss here.
Let us see the below example to understand how the short selling is done
Suppose share of company X is traded at USD 50 now.
One trader Mr. Smith believes that the Company will post a lower than expected annual result and the share price will be corrected heavily.
To gain profit out of the fall, he has borrowed 100 shares of Company C from a brokerage firm. The brokerage firm has the shares which were bought by other clients and used them for lending to Mr. Smith.
After borrowing the shares, Mr. Smith sells 100 shares of Company X in the market at USD 50 price per share. He receives total USD 5000 from the selling of the shares.
Suppose as per his prediction, the company announces poor annual result which leads to fall of share price to USD 40 within 2 trading sessions.
Mr. Smith buys 100 shares of Company X at the price of USD 40 per share, for which he pays USD 4000.
After that he returns back those 100 shares to the brokerage firm, where from he has borrowed.
Excluding the brokerage and transaction costs, he has made profit of USD 100 without any investment.
Risks involved in Short Selling
Short selling is done based on anticipations and predictions which do not have any base.
In the previous example, if Mr. Smith’s prediction became wrong and share price went to USD 70 per shares, it could have led to a loss of USD 2000 for him.
As there is no limit of share price going higher, the potential is infinity and it can become huge to put an investor in trouble.
During short selling, the traders borrow shares from the brokerage firm; these shares are owned by other clients. Failing to return back the shares within time can lead to huge problems for the brokerage firm if the number of borrowed shares is very high.
To reduce the risk, sometimes the brokerage firms keep margin money from the investors who borrow shares. As soon as the margin money is crossed, they buy back the shares at the market price to avert any potential problem. Here the trader losses all the margin money.
Naked Short Selling allows the traders to sell in the market without even borrowing or holding them. They are traded based on the promise of returning back within 2/3 days. It is very much riskier than the other short selling techniques as it increases the traders’ risk exposure significantly. Because of this, naked short selling is banned is some of the developed countries.
Risks involved in short selling is very high and it was responsible for huge market fall during the sub-prime crisis. But the hedge funds and some traders use this as an efficient tool to generate profit from the falling market, specially falling share prices.