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The stock market is a place filled with tools and strategies to help traders manage risks and earn profits. Of the many techniques available, shorting a stock is one. It is a concept that revolves around trading a stock that one does not own.
In today’s article, let us understand what shorting a stock is and what short interest means.
What does it mean to short a stock?
Shorting a stock or short selling is the process of selling a stock that one does not own. Short selling is a strategy used by bearish traders who expect the stock’s prices to fall further. Hence, they sell stocks they do not own and repurchase them when the prices decline, making profits from price differences.
What is short interest?
Short interest is a number that measures the number of open short positions. It is a percentage or a ratio that suggests the number of trades where traders are yet to buy back stocks and return them to lenders to close their short positions.
Short interest formula:
Short interest = The number of shares shorted / The total number of shares outstanding.
The process of shorting a stock
You must now be wondering how traders sell stocks without owing them. To understand that, let us go through the process of shorting:
- Borrowing: The first step to short a stock begins with analysing the market. Traders with a bearish outlook who predict the stock’s price to fall in the future use shorting as an option to make profits. To do so, they interact with their brokers to borrow the stock as a loan.
- Selling: Now that traders have the stocks, they offer them for sale in the stock market. Once a buy order is matched the stocks are sold. Here, traders sell the stocks that they have borrowed without owning them.
- Repurchase: A short position must be closed. Closing a short position means returning the stocks borrowed. So, when the stock’s price declines, the trader buys the stock from the market at a lower price.
- Return: The stock is returned to the lender and the trader earns a profit from the price differences. At this point, an active short position is considered closed.
Example of short selling:
Trader A wants to go short on Company ABC’s stock, currently trading at ₹150. He borrows 100 stocks from his broker and sells them at ₹150. Within a couple of days, the stock price is reduced to ₹115, as forecasted by Trader A. He then buys from the market at ₹115 and returns the stocks to the broker.
Trader A’s profit:
Selling price: 150 * 100 = ₹15,000
Buying price: 115 * 100 = ₹11,500
Profit: 15,000 – 11,500 = ₹3,500
What does short interest indicate?
Short interest is an essential tool indicating the market sentiments of a specific stock. When the stock interest is high, it is an indication that there are more traders with a bearish outlook. This could act as a warning for traders that the bearish dominance or a downtrend may begin, triggering them to decide their entry and exit points.
However, traders must note that a high short interest only indicates a bearish outlook. The downtrend may or may not happen. Hence, it is ideal to use short interest with other technical indicators to confirm whether the prices will fall.
Benefits and limitations
The ability of a stock’s short interest to determine market sentiments is its primary benefit. Understanding how investors think of the market helps regular traders and those with a contrarian approach to take trading positions.
However, short interest is a lagging indicator. It takes a few weeks for the required data to be available, which can lead to delays in decisions. The numbers are also prone to manipulation, leading to incorrect decisions. Hence, relying on short interest alone to make trading choices may be risky.
Bottomline
Short interest is a percentage or a number that shows the number of open short positions. It depicts the number of instances where traders have not closed their short positions by returning stocks to the lender.
A high short interest is an indication of a bearish outlook. It suggests that the stock’s prices may fall in the future. A high short interest also indicates high volatility in the market, making this a useful indicator for decision-making.
FAQs
Though there is no specific measure that suggests what an ideal short interest is, traders often consider a short interest of 10% or below as normal.
Anything above 10% is considered high. So, a short interest of 20% is indeed high, indicating that a significant number of traders are pessimistic about the stock.
High short interest is considered a bearish indicator.
Traders take short positions when they believe that the market will fall further. They borrow stocks at current prices, sell them, and then wait for the market to fall to buy the stocks back.
A high short interest is a situation where a large number of traders are waiting for the market to fall, to close their short positions, indicating a bearish outlook.
Short selling is allowed in India. However, there is a catch.
India’s stock market regulator, SEBI, does not allow traders to carry forward their short positions. This means traders must close their short positions on the same day, i.e., they must buy back shares on the day, similar to the process of intraday trading.
Hence, the concept of short interest for Indian stocks is not fully applicable.
Naked short selling is the process of selling shares without owning them or even borrowing them. While regular short selling involves borrowing shares to sell them, naked short selling revolves around selling shares without borrowing them. Such traders enter an agreement to deliver the shares on a future date at a pre-agreed price, by when they expect the prices to fall. So, they plan to acquire it at a lower price and sell it at a higher price.
This practice is illegal in India and many other parts of the world.
Short selling is considered a profitable strategy for bearish traders. However, it is quite risky. If the prices do not go down as expected, the losses while buying back shares can be unlimited.
Besides, traders must also face the brunt of margin calls since the stocks are borrowed from brokers.
Hence, short selling is profitable but risky. Analysing the market thoroughly is crucial.