Short Sale of Stocks

A short sale of stocks refers to the transaction in which the seller first borrows the Security from the Broker and then sells it in the open market and, thereafter, buys the Security back at an appropriate time to pay it back to the Broker. This is done to ensure profits, especially in case of drastic fluctuations in stock prices.

In Short Selling of stocks, there are more stringent rules laid down by the SEC due to the high risk and exposure in the same.  In Short Selling, settlement happens weekly, or it depends upon the agreed terms.

• Short sale of stocks refers to the sale of a stock or other securities the seller does not own, expecting to repurchase it at a lower price.
• Short selling allows investors to profit from falling stock prices. Short sellers aim to capitalize on price declines and generate a profit from the price difference by selling high and buying back at a lower price.
• Short selling involves borrowing shares from a broker or another investor to sell in the market.
• Short selling carries unlimited loss potential. If the stock price increases instead of decreasing, short sellers may face significant losses as they need to buy back the shares at a higher price to close their position. Losses can be less than the initial investment.

Short sale of stocks occurs when traders sell stocks that they do not own but borrow from another party. In this process, the buyer of the security buys back the stock from the broker to cover an open position. Such transactions are termed margin transactions in which the settlement of the trade happens on the net margins and not the actual delivery of the Stock.

While short-selling stocks, investors sell borrowed stocks, speculating a decline in the prices. These borrowed stocks, however, need to be returned in the same volume to the one they were borrowed from in the future. Doing this helps investors reap considerable profits in the event of the decline of the stock prices as anticipated.

There are certain guidelines that need to be followed for the short selling to be done by the investors in respect of minimum margins to be maintained with the Brokers.

In real estate, it refers to a transaction wherein the property which is mortgaged with the lenders is sold in the market at a value that is less than the debt owed on it. In this case, if the lenders agree to the transactions, the Net difference between the Sale price and the debt owned against it is referred to as a Short Sale.

Individuals can look at the following Wipro Limited stock price chart to understand the concept better.  

Source

As one can observe, the stock was in an uptrend, trading around $429 dollar per share. That said, it appeared that a significant downside move was on the horizon. Hence, individuals had the opportunity to short-sell the security and make financial gains. The chart shows that the short-selling strategy would involve placing a stop-loss order at Rs. 437.15 and setting a Rs. 420.15 target.

When a trader, for example, Sam, would short-sell 10 shares at, let's say, a price of $434.80, he would borrow the shares from his broker and sell them to the buyers, hoping that the price would fall. If the price reaches the target of 420.15, Sam would repurchase the shares and return them to the broker, closing the position and pocketing the profit. If the price increases instead of falling, Sam would incur significant losses. To minimize the financial risk, setting a stop-loss is crucial for all traders.

Note that individuals need to open a margin account with a broker and pay interest and commissions if they wish to use a short-selling strategy to make profits in equity markets.  

If individuals wish to improve their understanding with regard to how short sale of stocks works, they may consider looking at charts like these available on TradingView.

Let us consider the following examples to understand the short sale of stocks definition and its working properly:

Example #1

Let us assume that an investor Shorts Sells Security on the Exchange by borrowing the same from a Broker, i.e., 1000 shares @ $20 = $20,000. The stock price moves down by $2. In this case, the investor needs to buy back the Security from the Broker @ $18 in order to cover the position, and hence there is a profit of $2,000 on this transaction, which has been paid by the Broker to the investor.

Below mentioned are some of the Journal Entries that need to be passed after Short Selling.

The Stock moves down by $2 to $18.

At the time of settlement

In the Above Examples, the Trader makes $2,000 just by putting a trade on the Stock Exchange via a Broker without possessing that Stock in his Demat Account. For this, the Broker charges a certain amount of Fee to the Trader to execute the trade, which is known as a Transaction fee, which gets deducted from the initial margin the Trader has given to the Broker as a Security.

Thus the trade had made a profit just by selling the Security at a higher rate and then buying it back from the market when the rate dropped below the Sell rate, which has resulted in a net profit of $2,000 to the Trader and Fee income to the Broker for availing this facility.

Example #2

Let us assume that in the case of a Real Estate Transaction, ABC Limited owns a property whose market value is $5,00,000, and the debt owed against the same is $ 4,50,000. IF the Company wishes to sell the property at $ 3,50,000, it will have to take NOC from all the lenders in order to go ahead with the transactions since their Financial interest has been affected due to the lower realization in the same. If the lender agrees on the sale, it would be referred to as the Short Sale of the Deal by $ 1,00,000

Apart from helping investors with a backup in the event of loss anticipation, there are other benefits as well that make investors opt for it:

• Liquidity: The Investor who does not have money to trade in the Financial markets can trade by giving a small margin and building a bigger position.
• High Rewards: This comes with a high Risk and Return relationship wherein the Short Seller makes super profits in case of wild fluctuations in the Stock moving in favor of the investor.
• Ownership is not required: The Trader does not require to hold the Stock in order to trade.
• Monitor and Control of Investment: The Trader can secure his position by applying for various limits or Market price orders in order to cover his position so that he is secured from any kind of loss ahead.

Though the advantages are many, short selling of stocks may impose negative effects on investors too. Hence, they must be aware of the risks associated with the process. Here are a few disadvantages of short-selling stocks:

• High Risk: Since it is in the F&O market, the risk of losing a high amount of funds is more.
• Subject to Lenders Approval: Short Sale in a real estate transaction comes with a NOC from the existing lenders to settle at a low value of the property.
• High Margins: The Traders need to keep a high amount of margins with the Broker thereby securing his Financial interest in the event of.
• Regulations: There are various regulations set by the SEC and the Stock Exchanges in entering into a Short Sale transaction in the Financial market.
• Lengthy process: It is a lengthy process since the Short sale needs to be approved by the Lenders since the property will be sold at a lesser valuation as compared to the normal route.
• Opportunity Cost: Short Sale comes out with an opportunity cost wherein the Amount recovered shortly is a cost to the transaction and can be considered as an Expense in the same.

This has been a guide to what is a Short Sale of Stock. Here, we explain the concept with examples along with its advantages, and disadvantages. You can learn more about Financing from the following articles –

• Phantom Stock
• Blue Chip Stocks
• Small-Cap Stocks
• Floating Stock