Business on a rainy day!

"How can I sell the stock when I don't have any?"

asked one of my friends, reacting to the concept of Short Selling (or Shorting).

The same was my reaction when I first came to know about this concept!

It was confusing and difficult to digest.

It was easy to understand buying and then selling something

but selling something which you don't have and then buying it back later was perplexing!

This seemed like a wonder in stock trading to me!

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Let us understand short selling with the following example...

Assume that you sell umbrellas in your shop.

Also, assume that one fine day you run out of stock of umbrellas.

Unfortunately, it starts raining that morning!

"I would have made decent profit today had I got umbrellas in my stock!" you would have regretted!

"The 100 bucks umbrella would have sold for neat 150 bucks when it is raining like this!"

Pure demand and supply equation!

"Even if I place an emergency order on the umbrella supplier, the supply will not come till the evening!

If it stops raining by then, which it is likely to, demand and hence price of umbrellas will drop to 100 again!

Who knows even less than 100!"

Just then, you come across an idea.

You go to the neighbouring shop and ask for 2 dozen umbrellas on credit with a promise that you will return those in the evening!

You bring those umbrellas and sell them at 150 bucks each.

By the evening, the rain stops and the demand and hence the price of the umbrella falls to 100 per piece!

You buy 2 dozen umbrellas (same colour, brand and model) for 100 bucks each and return them to your neighbouring shop-owner!

This way you made a cool 50 buck on each of the 2 dozen umbrellas you never had in the first place!

You were "short" on supply and you still "sold" them!

You just "short-sold" them!

Similar thing happens in stock market when

expecting the stock price to fall

we place an order on our broker to short-sell x number of shares!

The broker borrows those stocks (from "someone" who has the stock but is unlikely to sell them for some time)

and sells them!

In the evening or whenever you ask your broker to cover your short positions,

the broker buys back the stock (hopefully at lower rate)

and returns them to the actual owner!

In this process, you earn the difference between the selling price of stock and its buy-back price

while your broker earns the brokerage!