What is short selling in stock market? Why isn't it illegal?

Have you sold something before you owned it in real life? Well, this is legally allowed in the stock market, but with a catch: you have to buy it back on the same day, irrespective of the price. 

Rohini was a happy, educated 26-year-old, who had just made about Rs 2 lakh when the stock market crashed recently. Her parents thought she was bluffing because they could not believe that one could make this kind of money, especially during a market crash.  

Rohini's father, Biju, on the other hand, was a total stock-averse person, who had worked hard all his life (and still not made enough money). Biju had lost his fortune in the 2008 stock market crash and had decided to stay away from the market since then. He had bought some stocks first, nurtured it, and when he was about to sell them, the market took it all away, leaving him in losses.

Since normally one could only make money when they buy a share at a lower price and sell them at a higher price later, Biju could never think of investing money when the market was bleeding and prices were falling every second day. It was impossible for him.

Rohini's surprised. She asked curiously: ''Dad, who told you that you could only buy a share first and only sell them later?'' 

Her dad cross-questioned her: ''Rohini, how can you sell something first when you don't own it in the first place?''

Though the normal practice in our lives is to buy something (home, gold, stocks, etc) first and then sell it off later, this only becomes profitable for us when the prices are rising over a period of time. If you do this when the prices are falling, you will obviously end up with losses. So how does one make money when the prices are falling?

Well, in the stock market, you can always make money, by short selling.

How does short selling work? Here's how Rohini did it: As the rupee value was sinking and foreign investors were withdrawing funds from the stock market, Rohini knew that the stock prices would crash. So she decided to opt for intraday trading every day for the next few days. (This is also known as Margin Intraday Trading or MIS)

She would start her trading period by selling some stocks every morning at 10 am and buying them back later at 2 pm. So as the market crashed every hour, she would sell at a higher price first and square off the position by buying at a lower price later. At the end of the day, there were zero shares in her portfolio but more profits in the bank.  

But how can you sell something that you don't have? Well, the government and the governing bodies (SEBI in India) allow investors to sell something they don't have, only if they can buy it back on the same day via intraday trading. So it's legally allowed. You can use this to hedge your portfolio or make money during a financial crisis since prices always fall during those times.   

How does this reflect? So, say when you sell 10 stocks first, your broker shows your position as '' - 10''. When you eventually buy back the same stock the same day, your broker shows it as ''+ 10'', thus leaving zero balance at the end of every trade.     

What if you short sell but don't buy it back? Say you sold 10 shares at Rs 100 and expected the prices to come down to say Rs 80 later on. But instead of coming down to Rs 80, the prices went up to Rs 110 or fell to Rs 90. You did not buy back those shares. Now what? Well, if you don't manually buy it back, the system automatically does it for you. Some brokers automatically set their systems to square off transactions at 3.10 or 3.20 pm, even though the market is open till 3.30 pm. 

A unique situation: Say you sold 10 shares first and you have been waiting to buy back these shares, but the stock has hit something called ''an upper circuit''. This means that the stock price has hit the maximum and now you cannot buy any shares because no one wants to sell them. There are only buyers for this stock. 

So how does one buy back shares when there are no sellers? Here your shares will be auctioned in an auction market between 3.30 pm to 4 pm by your brokers. Brokers will buy shares on your behalf at the available price and honour the contract. 

But beware:  Short selling can put you in terrible losses.

When you buy a stock say for 350 bucks, the maximum you can lose is only what you have put in the stock ie 350 or less. But when you sell your stocks first for say Rs 350, your benefits are limited to Rs 350 only. Now since stock prices can go up limitlessly, so can your losses. Ask Tesla short sellers who can tell you about their crores of short selling losses.