How does short selling work: Step by step guide

Do you know that an investor can even sell a stock that he/she doesn’t own? Confused how?

Well, this process is known as Short ­Selling!
Short Selling is basically a process of selling a stock that you don’t own in the hope of earning profits in future.

When an investor anticipates that the stock prices will fall, he resorts to Short Selling. When you short sell a stock, you need to borrow the stock from Clearing Corporations/Clearing houses. When the investor short sells a stock, the proceeds are credited to his account but after the stipulated period, it is mandatory for him to close the short and buy the similar number of stocks. If the prices of the stock actually falls, as expected then the investor earns a profit (because he sold the stock at a higher price earlier), but if the stock prices rise then the investor incurs a loss.

Let’s understand Short Selling better with an example:

Suppose Mr. Mohan expects the prices of XYZ Corporation to fall from Rs. 50 in the near future. He decided to short sell the stocks and so he borrowed the required shares. Assuming that Mohan is short selling 100 shares. After he short sells them, Rs. 5,000 will be credited to his account.

Case I:
Suppose the prices now falls down to Rs. 45, now is the right time for Mohan to buy the shares back. He’ll buy them at Rs. 4500 and while he sold the same shares at Rs. 5000 and therefore he will earn a profit of Rs. 500

Case II:
There might be a case where the prices rise and there is no prospect of them falling down again. Assuming they rise up to Rs. 70 will imply that he will have to buy these shares at Rs. 7000 while he sold them at Rs. 5000 and that’s how an investor can also incur a loss while short ­selling.

There is one more related process known as ‘Naked Short Selling’ which involves the same process as Short Selling except that it does not necessitates the investor to borrow the stock before making any trade. However, Naked Short Selling is not allowed in India as of now.

Coming back to the topic, Short Selling can either result in loss/profit or no gain no loss situation. To short sell, you need to analyze the markets very carefully. Being too early or too late can lead to losses. Usually, short selling is seen during a Bearish trend when the markets are expected to fall in general or when economy/particular sector is facing crisis.

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