I always hear about investors shorting a stock. What does that mean?

short selling

The question you always wanted to ask about shorting a stock

Buying comes naturally to everyone. We buy goods on a day-to-day basis for our regular need. But selling is something which normally a businessman or a salesman does.

In stock markets, too many investors and traders only buy. They are apprehensive about selling, even if they are holding the shares. The hope of holding on for a little more profit or not selling in the hope that the stock which is below their entry price comes back to their level has caused more damage to the retail investor than anything else. In investing and trading, it is the selling that is more important than buying.

Various studies have found out that even random purchase can give positive returns if the selling strategy is in place.

If selling is a difficult task, short selling is a foreign concept for many traders.

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What is short selling?

Short selling or more specifically short selling of stocks is the selling of a stock which one does not own. This form of selling is generally done with an intention of buying back the shares at a later point in the day.

Short selling is normally an intraday trading strategy adopted by stock market traders.

These trades are initiated based either on technical signals or if there is a negative news on the company or the sector. A short seller can cover his position in a matter of a few seconds to a few hours.

Since fear is a greater emotion than greed a short seller normally profits from a fast move in the stock price. As they say in the market stocks need buying power to move up but it can fall on its own weight.

The commitment of a short seller

As in the case of any intraday trade, a broker would ask for margin to trade on the buy side or short sell side. But unlike a buy trade, a sell trade has to be compulsorily squared off. In case a trader fails to square off the trade he will have to submit shares to the stock broker.

If the trader does not provide any share then the same are auctioned in the market which is a sort of fine imposed on the trader for not honouring his commitment.

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Share lending

The concept of share lending is prevalent in the developed world, where a short seller can borrow shares and sell it in the market and return it back when either his stop loss is triggered or profit target is achieved.

Many companies have fallen prey to short sellers globally, as a result of which laws for short selling by borrowing shares have more stringent rules.

In India short selling by borrowing shares has not picked up thought there are rules in place to do it. India, unlike many countries, allows online trading in futures and options of stocks, thus a trader can short sell a stock by participating in the derivative markets by either selling a future or buy a put option or selling a call option.

When to short sell a share

Based on technical analysis a trader sells a short due to many reasons. It can be done when the stock is in the overbought zone, or when there is a bearish pattern formation or when a bearish candlestick shows up. A moving average crossover on the downside or an important support level being taken off are other reasons to go short on a stock.

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Stock Market traders also trade on the short side in a stock where a negative news has appeared or if the company is expected to announce its results which they expect will be lower than market expectation.

One of the most commonly used strategy by traders is to look for the weakest sector and then pick the weakest stock in it to short sell.

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