What is Short Selling?

In simple words – sell first and buy later.

Short Selling – Selling of stocks that you do not own in your demat account. The goal is to profit from falling price of a stock (i.e. the trader is betting that the price of the security is likely to fall further and hence he can make a profit by buying it back at a cheaper price at a later stage).


Short Selling in Cash Market – Valid for an Intra-day period ONLY

In Indian equity markets, short selling is typically undertaken via the futures and options route and short selling in the cash market cannot be done for longer than ‘intra-day period’ (i.e. single trading session).

In other words, you can initiate the short trade (take short position) anytime during the day, but you will have to buy back the shares (square off) before the market closes. You cannot carry forward the short position for multiple days.

Example

Scenario 1: Rajat sold 1000 shares of IDFC Bank at Rs. 50 for intraday expecting the price to fall below Rs. 50 before the end of the trading session. He was able to buy back the shares at Rs. 48 and hence made a profit of Rs. 2 per share.

Note – If you sell any stock for Intraday you are expected to buy it back by the end of the day to close your position.

Scenario 2: For a moment, let us assume that in the above example, instead of declining; the price of IDFC Bank starts rising. The loss on the above transaction will depend upon the extent to which the stock price rises before Rajat is able to buy back the shares (i.e. close the short position).

Scenario 1 Sell Price  = Rs. 50 

Buy Price  = Rs. 48

Profit Booked  = Rs. 2

Scenario 2 Sell Price  = Rs. 50 

Buy Price  = Rs. 52

Loss Booked  = (Rs. 2)

Scenario 3: Now assume Rajat did not buy back/ cover his short position at the end of the day: SHORT DELIVERY

In such a scenario he will have to deliver these 100 shares of IDFC Bank on T+2 bases (i.e. within 2 days from the date of the trade). Since he does not have any shares, he would not be able to deliver and would default, thereby causing a Short Delivery.

Under a short delivery situation, the stock exchange would take up the issue and use AUCTION SETTLEMENT in the auction market which is conducted on T+2 day between 2:00 p.m. and 2.45 p.m.

What Happens in the Auction Market?

AUCTION SETTLEMENT PRICE – SEBI guidelines stipulate that the auction settlement will be at the highest price prevailing in the NSE/BSE from the trading day till the auction day; OR 20% above the closing price on the auction day, whichever is higher.

Auction day = T+2.

So in the example above, Rajat bought 100 shares of IDFC Bank at Rs. 50. Now on the auction day (in the auction market), Rajat’s broker was able to buy the shares at Rs. 54.

The price (including penalty) which Rajat will have to pay = AUCTION SETTLEMENT PRICE (Rs. 54) + BROKERAGE + PENALTY.

Penalty will depend upon the broker. Typically, brokers will charge you a penalty that will ensure that the AUCTION SETTLEMENT PRICE becomes 20% above the actual closing price at which the broker was able to buy the shares in the auction market.

So in the above case, Rajat will have to pay = AUCTION SETTLEMENT PRICE (Rs. 54) + BROKERAGE + PENALTY (Rs. 11 i.e. 20% of Rs. 54) = Rs. 66.

For a default of 100 shares, Rajat will have to pay the difference of Rs. (50-66)*100 = Rs. 1,600

As you will notice, it is very important that if you are short selling a stock, buy back the shares before 3:30 pm or you could end up paying up to 20% penalty in addition to the price at which the actual delivery (i.e. buy back of shares happens).

Other Important Points

  1. Effectively the settlement of the original trade will be in up to T+5 days (T+2 for auction and up to 3 days after that for settlement of the auction trade).
  2. Even if the broker was able to buy back the shares at a price below the price at which you short sold. For example at Rs. 48 in the above example, Rajat will get nothing and any profit will go to the investor protection fund maintained by SEBI. Basically, short selling and not covering your position is a bad thing to do!
  3. If no seller becomes available in the auction market, then the deemed auction settlement price along with the penalty is set at THE HIGHEST PRICE AT WHICH THE SHARE TRADED IN THE SESSION BEFORE THE AUCTION DATE + 20% OF THAT PRICE.

Short Selling on Margin

The problem becomes more startling when you do short selling on margins. Margin limit allows traders to take more exposure and gain from market movement with limited money.

Types of Margins which a Broker Allows*

Regular Margin = 4 TIMES THE AVAILABLE LIMIT*

* Based on the margins we work with, different brokers will have different margin limits).

With this margin facility, you can buy/sell stocks for up to 4 times your available limit.

Available limit is calculated as CASH AVAILABLE VALUE OF YOUR HOLDINGS after haircut.

Suppose, you have a cash of Rs. 1, 00,000, and stocks of Rs. 2,50,000 in your account

Your Available Limit = Rs 1,00,000 + Rs. 1,75,000 (Haircut on stocks @ 30%) = Rs. 2, 75,000.

You can take short selling position of upto Rs. 11,00, 000. That is 4 times your available limit.

If you short on margin and then default, the penalty could be quiet hefty and may erode a substantial part of your capital.

Another Margin Product which many Brokers Offer – Margin Plus Product

MARGIN PLUS = 20 TIMES THE AVAILABLE LIMIT

In this margin facility, the allowed exposure is 20 times the margin. Thus if you have a margin of Rs. 2,75,000  you can take short selling position of Rs. 55, 00,000.

Margin Plus is allowed ONLY FOR AN INTRADAY ORDER PLACEMENT.

You need to square off the position 30 min before the closing bell of the market; otherwise the same will be squared off by the broker between 3 PM – 3.15 PM at whatever is the prevailing price. Further, the positions on margin plus are also squared off automatically if the loss reaches 70% of your available limit.

Final Word

Short selling can be a great way to multiply your trading gains but a default on your short position will be penalized heavily.