What Is Short Selling in Trading? Explained with Example & Risks

Short selling is a trading strategy where investors make money by predicting that a stock’s price will go down. 📉 Normally, people profit in the stock market by “buying low and selling high, 📈 ” which is called a long position and works well when stock prices are expected to rise.
In contrast, a short position is used in a bearish market when stock prices are expected to fall.
What is short selling? 🔄
Short selling is a strategy that’s different from the usual way of investing. Instead of “buying low and selling high, ” people who short sell expect stock prices to drop and try to make money from that fall.
How Short Selling Works
To execute a short sale, traders borrow shares from a broker-dealer and sell them at the current market price, thereby opening a short position. They then wait for the stock price to drop. To close the position, traders must eventually repurchase the shares they initially sold short.
💰If the stock price falls as expected, traders profit from the difference between the initial selling price and the lower repurchase price. However, if the stock price rises instead, the trader faces potential losses. Beyond speculation, investors and fund managers also use short selling as a hedge against the downside risk of holding a long position in securities or related assets.
Short selling in the stock market is a speculative strategy that theoretically carries unlimited risk. Typically, only experienced investors engage in short selling.
What is Short Selling in Trading and How Does It Work?
Let’s understand how short selling works in the stock market with a simple example.
Example:
Here’s a simplified version of the example in Indian Rupees:
Short Selling Example
Imagine you think the shares of XYZ Ltd.—currently priced at ₹500 per share—will drop in value over the next three months. Here’s what happens step-by-step: 🛠️
- Borrow and Sell Shares:
You borrow 100 shares of XYZ Ltd. from your broker and sell them in the market at ₹500 each.- Total money received = 100 shares × ₹500 = ₹50,000.
- Price Falls:
A week later, XYZ Ltd. announces poor quarterly results, and its share price drops to ₹400. - Buy Back the Shares (Close the Position):
You buy 100 shares at the new price of ₹400 each to return them to the broker.- Total money spent = 100 shares × ₹400 = ₹40,000.
- Profit Calculation:
The profit from the short sale is the difference between the selling price and the buying price:
₹50,000 (selling price) – ₹40,000 (buying price) = ₹10,000.
Your Profit = ₹10,000 (excluding brokerage fees and taxes).
🤔 Think of it like this: You “borrowed” something (shares), sold it when the price was high (₹500), and then bought it back when the price dropped (₹400). The difference between the two prices is your profit.
So remember,
Sell when high.
(and)
Buy when low.
Advantages of Short Selling 🟢
Here are the key advantages of short selling:
- Potential for significant profits if the anticipated price decline occurs.
- The only costs involved are margin maintenance, commissions, and any applicable dividends.
- It serves as an effective strategy for hedging against downside risks in securities or related assets.
Disadvantages of Short Selling 🔴
Here are the main disadvantages of short selling:
- Traders who short sell are exposed to unlimited risk, unlike the limited risk seen in traditional trading.
- Short selling requires borrowing shares from a broker, which means traders must pay interest on the borrowed stocks and maintain a margin. If the margin falls due to market changes, traders may need to provide additional funds or close their positions.
- Timing is crucial in short selling. If a trader shorts a stock too early, they may face prolonged costs to maintain the position. If they act too late, the stock may have already dropped significantly in price.
- Traders can experience a short squeeze when buying back shares. This occurs when a stock has high short interest, and if its price rises, short sellers rushing to cover their positions can push the price even higher, leading to a short squeeze.
In conclusion 😊
Short selling is a strategy that allows investors and traders to benefit from falling stock prices. Individuals with a negative market outlook can borrow shares through their broker, sell them at the prevailing market rate, and later repurchase them at a potentially lower price, keeping the difference as their profit.
⚠️ Risk of losses on the short sale is theoretically infinite. A stock’s price could continue to grow indefinitely. Short selling is best used by experienced traders who understand the dangers.
Learn more: Short selling