Mint Explainer: What is short selling and why is it in the news again?

livemint.com:

Mint explains short selling, its pros and cons, and the rules governing it in India. The most common way investors look to make money is simple – buy a stock whose price you expect to increase over time and sell it later, hopefully for a profit. This is called “going long" on a stock.

Short selling is the exact opposite – it is a bet that the stock will fall, not rise. Short selling or “shorting" a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the price will soon fall. If it does, the trader can buy the shares back for less, return them to the broker and pocket the difference (minus any loan interest).

Large institutional investors and wealthy investors use short positions to hedge their portfolios. Say an institutional investor has large equity exposure to three Nifty 50 companies. There is always a risk of the stock prices going down.

To reduce this risk, the investor takes short positions on the three stocks or on the entire Nifty 50 index to ensure if stock prices fall, the losses on his long positions will be compensated by profit from his short positions. But investors also use short selling as a form of speculation, taking on extremely high risk in hopes of exceptional returns. This is dangerous, as short selling has the potential for unlimited losses.

In a traditional stock purchase, the most you can lose is what you paid for the shares, but the upside potential is theoretically limitless. When you short a stock, this is reversed. Your potential gains are capped because the stock price cannot fall below zero, but losses are theoretically unlimited because it can rise indefinitely.