Navigating the world of short selling: What it is, benefits and risks involved

Short selling is the practice of selling borrowed securities – such as stocks – hoping to make a profit by buying them back at a price lower than the selling price. In other words, when you short sell a stock, you’re looking to profit from a decline – rather than an increase – in price.

Read on to discover the dynamics of short selling, its advantages, disadvantages, and how it differs from conventional investing.

Table of contents

1. Understanding short selling
2. How short selling works
3. Factsheet of short selling
4. Key facts about short selling
5. What are short selling metrics?
6. Benefits of short selling
7. Drawbacks of short selling
8. Risks of short selling
9. Example of short selling for a profit
10. Short squeeze explained
11. Difference between regular investing and short-selling
12. Short selling regulations in India
13. Example of short selling (profit, loss & hedge)
14. How to start short selling in India

Understanding short selling

Short selling involves selling a stock that you do not have. You borrow shares from a broker or a fellow investor, sell them at the prevailing market price, and later buy them back and return them to the slender. You hope to buy back the shares at a lower price and profit off the difference between the sale and purchase prices.

Read Also: The world of stock trading: Definition, forms and history

How short selling works

To engage in short selling, you typically need to open a margin account with a broker. This account allows you to borrow money or securities from the broker to execute trades. Here’s a step-by-step overview of how short selling works:

1. Identify a stock to short: You select a stock that you believe will decrease in value.
2. Borrow shares: Your broker locates shares to borrow, often from other clients or institutional lenders.
3. Sell the shares: You sell the borrowed shares at the current market price.
4. Monitor the stock: Keep an eye on the stock's performance, waiting for its price to drop.
5. Buy back the shares: Once the price falls, you buy back the shares at the lower price.
6. Close the position: Return the shares to the lender and keep the profit, minus any fees.

Factsheet of short selling

• Margin requirements: Short selling requires maintaining a margin account, which involves paying interest on borrowed shares and meeting minimum balance requirements.
• Dividend payments: You are responsible for paying any dividends declared during the short period to the lender.
• Stock splits: If the stock splits, you'll need to return more shares at a lower price.
• Short squeeze: A situation where many short sellers are forced to buy back shares quickly, driving up the stock price.

Key facts about short selling

• Short selling means selling shares you do not currently own, by first borrowing them (usually via your broker) and then selling in the market, expecting the price to potentially fall.
• If the price drops, you buy back the shares at the lowered price and return them to the lender, keeping the difference (minus costs) as profit. If the price rises, you incur a loss.
• In India, short selling is allowed only under a regulated framework.
• Short selling often uses margin, meaning you must maintain collateral and may face margin calls if prices move against you.
• It is commonly used for trading, speculation, and hedging.

What are short selling metrics?

Two key metrics help track short-selling activity:

1. Short interest ratio (SIR)- This measures the number of shares shorted compared to the total shares floating in the market. A high SIR indicates strong bearish sentiment.
2. Short interest to volume ratio- Also known as the days-to-cover ratio, it shows how many days it would take to cover all shorted shares based on average trading volume.

Benefits of short selling

• Profit from declines- Short selling allows you to profit from falling stock prices, providing an alternative to traditional long positions.
• Market efficiency- It helps maintain fair market prices by identifying overvalued stocks and increasing market liquidity.
• Hedging- Short selling can be used to hedge against potential losses in long positions.
• Liquidity- Short selling increases trading activity in the market, thereby adding liquidity.

Drawbacks of short selling

• High risk: The potential for unlimited losses exists if the stock price rises significantly.
• Costs: You incur costs such as interest on borrowed shares, dividends, and commissions.
• Margin call: If the stock price rises, you may face a margin call, requiring additional funds to maintain the position.

Risks of short selling

• Infinite loss potential- There is no cap on how high a stock price can rise, leading to potentially catastrophic losses.
• Short squeeze- A rapid increase in stock price can force you to buy back shares at unfavourable prices.
• Market volatility- Unpredictable market movements can lead to unexpected losses.

Example of short selling for a profit

Imagine you short 100 shares of XYZ stock at Rs. 500 each. If the price falls to Rs. 400, you can buy back the shares and return them to the lender, earning a profit of Rs. 10,000 (Rs. 500 - Rs. 400 per share). However, if the price rises to Rs. 600, you'll incur a loss of Rs. 10,000.

Short squeeze explained

A short squeeze happens when a heavily shorted stock’s price starts rising sharply, prompting short sellers to buy back shares quickly to try and limit their losses. This urgent buying generally adds more demand, potentially pushing the price even higher and triggering further covering by other shorts—a feedback loop.

Typical ingredients of a short squeeze include:

• High short interest (large percentage of free-float sold short).
• A positive catalyst such as strong earnings, news, or unexpected buying pressure.
• Limited free-float or low liquidity, which magnifies price jumps.

For short sellers, squeezes can cause rapid, theoretically unlimited losses, which is why short selling is considered high-risk.

Difference between regular investing and short-selling

Regular investing involves buying stocks with the expectation that their prices will rise. In contrast, short selling involves selling borrowed stocks with the anticipation that their prices will fall. While traditional investing limits your potential loss to the amount invested, short selling exposes you to potentially unlimited losses if the stock price surges.

Also Read: What is the Process of Selling IPO Shares

Short selling regulations in India

• SEBI defines short selling as selling a stock the seller does not own at the time of trade and permits it for all classes of investors, subject to prescribed conditions.
• Naked short selling is not permitted; sellers must ensure delivery at settlement, and exchanges may impose penalties for short delivery.
• While intraday short selling in the cash market is generally permitted, stock lending and borrowing (SLB) and derivatives-based short positions are available only in stocks that meet specified eligibility criteria, which are reviewed periodically.
• Settlement follows a rolling T+1 cycle, and brokers are required to enforce margins, risk controls, and delivery mechanisms, including SLB, where applicable.

Retail investors typically take short positions through intraday cash trades, futures, options, or SLB-backed transactions, in line with broker and exchange regulations

Example of short selling (profit, loss & hedge)

Speculative short (profit scenario)

• A trader expects Stock A at ₹1,000 to fall.
• Borrows 100 shares and sells them: receives ₹1,00,000.
• Price falls to ₹800; buys back 100 shares for ₹80,000 and returns them.
• Gross profit = ₹20,000 (before brokerage, taxes, borrowing fees).

Speculative short (loss scenario / squeeze risk)

• If instead the price rises to ₹1,300, buying back 100 shares costs ₹1,30,000.
• Loss = ₹30,000 plus costs—losses may grow if price keeps rising, unlike a long position where maximum loss is the invested amount.

Hedging example

• An investor holds 1,000 shares of Stock B for the long-term but may fear a near-term fall due to results.
• They short futures or borrow and short some quantity of Stock B.
• If the price falls, losses on the long position are partly offset by profits on the short, acting as a temporary hedge.

*Examples for illustrative purposes only.

How to start short selling in India

• Open a trading + margin account with a SEBI-registered broker that supports short selling and F&O trading. Complete full KYC and risk disclosure forms.
• Understand product routes:
  • Intraday short in equity (must cover within the day).
  • Futures contracts (no borrowing needed; but marked-to-market daily).
  • Options (buying puts or selling calls as synthetic shorts).
  • Stock Lending and Borrowing (SLB) for delivery-based shorts.
• Check margin and risk: You are advised to learn margin requirements, penalties for short delivery, and broker-specific rules on which stocks and segments can be shorted.
• Start small and use risk controls: You may use stop-loss orders, position sizing, and avoid concentrated bets, especially in illiquid or highly shorted counters.

Conclusion

Short selling is a sophisticated trading strategy that requires careful consideration of risks and rewards. While it offers the potential for high returns and helps maintain market efficiency, it also involves significant risks, including unlimited potential losses. As you explore short selling, remember that it is not for the faint of heart. For those interested in more conservative investment strategies, mutual funds can provide a diversified portfolio with lower risk, though they may not offer the same speculative opportunities as short selling.

Read Also: A chance to make gains when the market falls: Understanding inverse ETFs

FAQs:

What is short selling in the stock market?

Short selling is the practice of selling stocks you do not own, typically by borrowing them from a broker, with the intention of buying them back later at a lower price to make a profit.

Why is short selling also known as margin trading?

Short selling is often referred to as margin trading because it involves borrowing money or securities from a broker, which requires maintaining a margin account.

What is the major advantage of short selling?

The major advantage of short selling is the ability to profit from declining stock prices, which can be particularly beneficial in bearish markets.

Is short selling legal in India?

Yes, short selling is legal in India and is regulated by the Securities and Exchange Board of India (SEBI).

Is short selling only for intraday?

No, short selling is not limited to intraday trading. You can hold short positions for as long as you wish, provided you meet the margin requirements and the lender does not recall the shares.

How does short selling differ from buying stocks?

When you buy stocks (go long), you first pay money to acquire shares and potentially profit if prices rise; your maximum loss is generally limited to the amount invested. In short selling, you first sell borrowed shares and potentially profit if prices fall, but potential losses could theoretically be unlimited if the price keeps rising.

What are the risks of a short squeeze?

A short squeeze may cause rapid price spikes, forcing short sellers to cover at much higher prices. This may lead to:

• Large, sudden losses.
• Margin calls and forced liquidation.
• Slippage and poor fill prices due to low liquidity.

Can retail investors short sell stocks?

Yes, retail investors in India may short sell within SEBI’s framework. Naked short selling and failure to deliver are not allowed.

What is naked short selling?

Naked short selling is selling a stock short without first borrowing it or ensuring it can be borrowed, risking failure to deliver at settlement. This practice may distort supply and is explicitly banned in India; all short sellers must arrange for timely delivery.

Do you need a margin account for short selling?

Yes. Short selling normally requires a margin account, because you borrow shares and the broker needs collateral against potential losses. Margin requirements vary by stock, product, and broker risk policy.

How is short selling regulated in India?

Short selling is governed by SEBI’s Short Selling and SLB frameworks:

• Investors may short-sell within prescribed rules.
• Only specified stocks can be shorted.
• Naked short selling is banned; delivery obligations are enforced with penalties.
• Exchanges and brokers must monitor and report short interest and implement robust risk controls.