Investment School: What is short selling?

What is short selling?

Most of us are taken back with the stock market crash of late eroding our investment value, but you would be surprised to know that you can make profits even in a crashing market. Want to know how is that possible at all? To know how to make money in a bear market, we need to understand the concept of short selling.

What is short selling?

Short selling is selling of a stock which is not owned by a seller. When a trader feels that the stock price of a particular company will fall in the near future, he indulges in short selling. Let us see how it works with a simple example.

Eg. Suppose say, trader Ram feels that stock price of company XYZ currently trading at 1000 rs will go down significantly in the near future due to market correction or any other reason. Ram borrows certain number of stocks,say 20, of company XYZ from his broker for 1000 rs/share.The commitment is that he will have to return back 20 shares to the broker on a specified date in the future say in one month's time.

After purchasing the stock at 1000 rs, Ram immediately sells the stock at 1000 rs and gets 20,000. As expected the stock price of the company XYZ falls by say 100 rs and is at 900 rs at the end of one month. So Ram buys back 20 shares of XYZ at 900/share thereby spending 18,000 and gives back the shares to the broker.

Hence Ram has gained 2,000 from short selling of company XYZ.

Risk Involved

Making money is not that easy. So once you buy the stocks assuming that it's price will go down, what if the price begins to rise due to the overall market sentiment and in these days, where the market volatility is very high the markets can go up and down in a days time and hence there is significant risk involved in short selling.

So should we not indulge in short selling at all? If involved how to trim our losses? The answer is short covering. Let us digg on that in the upcoming posts.

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