Short selling occurs when an investor borrows securities, sells them in the open market and aims to buy them later for a reduced price. Short sellers bet and win by rooting for lowered stock prices. This can be compared with long investors who want the cost to go up.
The main question that arises in everyone’s mind regarding short-selling and covering is this: How can an investor sell something that s/he does not own? And how are they allowed to sell borrowed shares of a company to indulge in short trading?
The simple answer is that the Securities and Exchange Commission of India (SEBI) enables this trade practice in the market and allows investors to indulge in short trading. The only prerequisite is that it needs to be started and finished within the same day of a market cycle; you cannot carry it over to the next day or period.
The short position is a procedure used when investors expect stock prices to fall in the short term, perhaps in the coming days or weeks. It involves borrowing stocks and selling them at a high price, then repurchasing them at a low price and returning them to the stockbroker.
The short selling process – how to do it?
To sell short, you first need to borrow the assets you want to bet against. Your broker gives you the details of potential stocks that might fall out in the coming days. You then request to borrow the shares. The broker attains another investor who owns the shares and agrees to return the shares on time. You get the shares after this journey.
Your broker lends you those shares as you are shorting a stock that you do not own. You can then sell the borrowed stocks at market value, buy those stocks at a lower price, and our broker will return the claims to the lender.
You usually do not need money to buy stocks through an intermediary. But in some cases, you have to pay for this trade. In the case of Hard-to-borrow (HTB) stocks, when there is a limited supply of stock for short selling, you must pay a daily stock borrow fee based on the price and availability of the stock.
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Short selling has a tremendous risk/reward ratio. It can offer significant gains, but losses can rise quickly and infinitely due to margin calls.
Example
For instance, a dealer sells short 100 shares of XYZ at Rs. 20 (total Rs. 2000), based on the estimates that those shares will head lower. When XYZ declines to Rs. 15 (Rs.1500), the trader buys back XYZ to cover the short position, booking Rs. 500 profits from the sale.
What is short covering?
Short-covering is the acquisition process of securities to close a short-term open position to either realise a profit or a loss. It requires acquiring the same stake that was initially sold short and handing back the shares borrowed originally for the short sale. This type of transaction is known as ‘buy to cover’.
Short-term collateral (if the asset is redeemed at the point of sale) may result in a profit or loss, whichever is greater. Short covering is required to close an open short position. The short side is profitable when it is paid out at a price lower than the original trade. If you pay a higher expense than the initial transaction, you incur a loss.
Short squeeze
When a big deal of short covering occurs in a security, it may result in a short squeeze. Resellers are forced to liquidate positions at progressively higher prices as they lose money, and their brokers invoke margin calls.
Selling under pressure (squeeze) is an abnormal condition caused by a rapid increase in a stock or other security’s trading price. In case of a short reduction, the deposit must have an unusual degree of short-sellers holding positions in it. The squeeze begins when the price unexpectedly rises. This position is essential for retail investors’ strategy as short-sellers reduce losses by exiting their positions.
The bottom line is this: the Indian stock markets’ regulatory body and government rules give the option of short trade and related practices, so why not use them vigilantly to make profits?
