Demat account: What is short selling and how does it work? MintGenie explains
Short selling is a strategy employed by experienced investors to profit from downward price movements by selling borrowed shares at a high price and repurchasing them at a lower price.
If you've watched the 'Scam 1992' series, you might remember the scene on short selling, where Harshad Mehta's character describes the process of selling shares in the stock market without actually owning them.
Investors often confuse the concept of short selling as the process looks tricky and involves selling shares that one doesn't actually own. However, this strategy is often employed by experienced investors in the stock market, particularly during periods of declining stock prices.
It enables investors to profit from downward price movements by selling borrowed shares at a high price and then repurchasing them at a lower price to return them to the lender.
This practice allows investors to capitalise on market volatility and generate returns irrespective of whether the market is bullish or bearish. In this article, let's delve into the concept of short selling, its benefits, and how to implement short-selling strategies both with and without a demat account.
Understanding demat and trading accounts
Engaging in the stock market involves two distinct activities: trading and investing. Trading entails frequent buying and selling of shares to capitalise on stock price fluctuations, while investing involves purchasing company shares to become a shareholder, participating in the company's growth, and potentially earning capital gains through stock appreciation and dividends if the company is dividend-paying.
To undertake these activities, you require both a trading account and a demat account, which can be opened with a depository participant.
Demat Account: A demat account serves as a secure repository akin to a bank savings account where various securities such as shares, debentures, bonds, government securities, and mutual fund units are stored in electronic form. For instance, if you buy shares, they will need a place to store them until you sell them. A demat account serves this purpose by safeguarding your securities in electronic form until they are sold in the market.
Trading Account: A trading account functions akin to a current account in a bank, primarily used for buying and selling securities (stocks, derivatives, and commodities) within short time frames, typically aiming for capital gains. This account is suited for traders with short-term investment horizons, aiming to capitalise on market volatility and price movements.
What is short selling?
Short selling is the sale of a security that the seller does not own and is one of the long-standing market practices.
Regulators in many securities markets globally have recognised short selling as a legitimate investment activity, particularly in markets with active equity derivatives, such as stock futures.
In the Indian securities market, "short selling" is defined as "selling a stock which the seller does not own at the time of the trade."
For example, let's say you anticipate a stock's price will decline in intra-day trading and aim to profit from this. You decide to execute a short-selling strategy by selling the stock at ₹100 per share, even though you don't currently own it; instead, you borrow it from the broker.
Later, the stock's price indeed falls to ₹80, at which point you repurchase it. Through this transaction, you've earned a profit of ₹20.
In simpler terms, when you first buy and then sell, it's termed a long buy strategy, indicating an expectation of the stock's rise. Conversely, when you first sell and then buy, which is called a short strategy, you anticipate the stock's decline.
Who is eligible for short selling?
All categories of investors including retail investors and institutional investors are allowed short selling. On January 05, 2024, SEBI issued the latest framework for short selling.
Under this framework, institutional investors are required to disclose upfront at the time of order placement whether the transaction involves short selling. On the other hand, retail investors have the flexibility to make a similar disclosure by the end of the trading hours on the transaction day, in accordance with SEBI guidelines.
How to apply the short-selling strategy
To apply the short-selling strategy using your demat account, you simply sell shares at a higher price that you anticipate will decrease during the intraday period. Later, you repurchase the same shares in the same quantity at a lower price. The difference between the sell price and the buy price constitutes your total profit for each share.
Alternatively, you can implement the short-selling strategy without a demat account but with a trading account. This type of account is specifically designed for trading purposes.
FAQs
Is short selling permitted in the Indian securities market?
Yes, short selling is legal in many securities markets worldwide, including in India.
Is naked short selling allowed in Indian markets?
No, naked short selling is not permitted in the Indian securities market. All investors are required to deliver the securities at the time of settlement.
Can I carry forward my short positions?
No, short selling must be done on an intraday basis. You can initiate the short trade anytime during the day, but you must buy back the shares (square off) before the market closes.
Are there any risks associated with short selling?
Yes, unlike traditional investing, short selling carries the risk of unlimited potential losses if the stock price rises unexpectedly, forcing the investor to buy back the shares at a higher price.
Do I need to pay more margin for short selling?
Yes, short selling typically requires you to maintain a higher margin in your trading account compared to regular trading.
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