14.11 Short selling transactions

Suppose that you, after painstaking research and analysis, have decided that the company ABC is flat on the floor. The stock is currently trading at Rs.65 but you predict it will trade much lower in the coming days. In order to capitalize on the decline, you decide to short sell shares of ABC. Let’s discuss how the transactions would unfold.

Step 1: You can set up a margin account with a broker. Or else you need to have a healthy cash account. Margin account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. As we discussed earlier, these stocks can come from the brokerage firm’s own inventory, the margin account of one of the firm’s clients or from another brokerage firm.

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

One of two things can happen in the coming months:

IDEAL SCENARIO:

Stock Price Sinks (Price Goes To Rs 40)

You borrowed 100 shares of ABC at Rs 65             = 6500

Bought back 100 shares of ABC at Rs 40               = 4000

YOUR PROFIT IS EQUAL TO  2500

WORST SCENARIO:

Stock Price Rises (Price Goes Up To Rs 90)

You borrowed 100 shares of ABC at Rs 65            = 6500

You bought back 100 shares of ABC at Rs 90       = 9000

YOUR LOSS IS EQUAL TO 2500

Clearly, short selling can be profitable. But then there’s no guarantee that the price of a stock will go the way you expect it to.