What is Short Selling? Concept, Opportunities and Challenges in Nepal

Short selling is an advanced trading strategy that allows investors to profit when the price of a stock decline. In a traditional long position, you buy Stock/shares expecting the price to rise. In short selling, you sell shares first (that you do not own) by borrowing them and later buy them back (hoping) at a lower price to return to the lender. The difference becomes your profit. This strategy is common in mature markets like the United States but is not yet available on Nepal stock exchange (NEPSE).

How Short Selling Works?

Unlike long position, short selling process follows following steps (like US practices under Securities and Exchange Commission, SEC rules):

• First, the short seller borrows stock from a dealer, broker or an institutional investor who is willing to lend them. The lender usually charges a borrowing fee. Once stocks are borrowed, the short seller immediately sells them in the open market at the current market price and receives the proceeds in their account after settlement.
• There is no fixed time limit to close the position. The short seller can hold the short if they maintain the required margin in their account. However, the lender can recall the stock at any time, or the broker can force closure if conditions change. When the investor decides to close the position (or is forced to), they buy back the same number of stock in the market which is called “covering” the short and return those stock to the lender.
• The profit or loss is calculated as the difference between the initial selling price and the price at which the stocks are bought back, minus all costs such as borrowing fees, interest in any margin used, and any dividends that must be paid to the original lender during the period.

Key Players in Short Selling:

Several parties play important roles in making short selling possible. The short seller is the investor or fund manager who believes the price will fall. The dealer or broker arranges the borrowing of stocks, executes the trades, and manages the margin account. The stock lender is usually a large institutional investor (such as mutual funds, pension funds or stock dealer itself) that lends out stocks in exchange for a lending fee. The regulator, such as the US Securities and Exchange Commission (SEC) or Nepal’s Securities Board of Nepal (SEBON), sets the rules and monitors for manipulation. Finally, clearing and settlement members ensure that trades are settled smoothly and reduces counterparty risk.

Types of Short Selling:

There are three main types of short selling.

• Covered short selling is the standard and most regulated form, where the seller borrows the actual stocks before selling them. This ensures the stocks can be delivered and is considered safer.
• Naked short selling occurs when the seller sells stocks without first borrowing or locating them. This practice is highly risky and often restricted or banned in regulated markets because it can lead to “failure to deliver” shares and potential market manipulation.
• Derivatives-based shorts involve taking a short position indirectly through financial instruments such as put options or futures contracts, without physically borrowing the underlying stocks. This method is popular in the US and major exchanges for hedging purposes.

Simplified Example: Long vs Short Investment

Assume stock trades at Rs. 100 per share.

1. Long Investment (Cash)

You buy 100 shares with your own money → Invest Rs. 10,000.

• Price rises to Rs. 120 → Profit = Rs 2,000.
• Price falls to Rs. 80 → Loss = Rs. 2,000 (maximum loss limited to investment).

2. Short Selling (Cash Margin)

You borrow and sell 100 shares at Rs. 100 → Receive Rs. 10,000.

• Price falls to Rs. 80 → Buy back for Rs. 8,000 → Profit ≈ Rs. 2,000 (minus fees).
• Price rises to Rs. 120 → Buy back for Rs. 12,000 → Loss ≈ Rs. 2,000 (plus fees). No fixed time limit to cover.

On Margin (Leveraged Short)

You use margin (e.g., put up Rs. 5,000–7,500 of your own capital).

• Price falls to Rs. 80 → Profit is magnified (e.g., Rs. 4,000+).
• Price rises sharply → Loss exceeds margin → Margin call and possible force closure at a big loss.

Short Selling in Nepal: Current Status and Background

As of now, short selling is not yet permitted on the Nepal Stock Exchange (NEPSE). However, the topic has become very popular among investors, brokers, fund managers and market analysts. The Securities Board of Nepal (SEBON) has publicly stated its intention to introduce short selling as part of ongoing efforts to modernize Nepal’s capital market, improve price discovery, and provide better risk management tools. This announcement has generated significant discussion and is seen as a sign of the market’s gradual maturation

Opportunities in Nepal

• Better Price Discovery: Short sellers can highlight and correct overvalued stocks, leading to more accurate pricing and reducing market bubbles.
• Hedging Capability: Investors and institutions can protect their portfolios from market downturn.
• Increased Liquidity and Market Depth: Short selling generally increases trading volume and makes the market more efficient.
• Attraction of Sophisticated Capital: It could draw more institutional and foreign investors, supporting overall market development.

Challenges in Nepal

• Infrastructure Gaps: Nepal lacks a fully developed securities lending and borrowing system, efficient margin financing, and advanced surveillance tools.
• Volatility Risk: In a small and retail-dominated market, short selling could amplify price swings or cause short squeezes.
• Investor Experience Gap: Most Nepali investors are new to the market and may not fully understand the high risks involved.
• Regulatory Preparedness: SEBON and NEPSE must implement strong rules, disclosure requirements, and safeguards before introduction.

Required Investor Awareness

• Unlimited Loss Potential: Unlike long positions, losses can be unlimited if the price rises sharply.
• Margin Call Risk: Using leverage can force you to add money quickly or face automatic closure.
• Additional Costs: Borrowing fees, interest on margin, and possible dividend payments to the lender.
• Short Squeeze Risk: When many short sellers cover at the same time, the price can spike dramatically.
• Regulatory Compliance: Investors must follow strict rules on borrowing, reporting, and settlement once introduced.

Real world example: GameStop Short Squeeze (2021)

In early 2021, several hedge funds had heavily shorted GameStop (GME) stock, believing the company was struggling. Retail investors on Reddit’s WallStreetBets coordinated massive buying. The stock price skyrocketed from around $20 to nearly $483 in January 2021. Short sellers faced huge losses (billions of dollars), and many were forced to cover their positions at extremely high prices, a classic short squeeze. This event highlighted both the power of short selling and its extreme risks when sentiment turns against shorts.

Conclusion

Short selling is a powerful but risky tool that can enhance market efficiency when introduced with proper regulation and infrastructure. SEBON’s plan to bring it to Nepal is an important step toward a more mature capital market. However, success will depend on strong rules, robust systems, and well-informed investors. In the meantime, participants in Nepal’s market should continue focusing on individuals risk appetite and multiple investing strategies.

Short selling involves substantial risk and might not be suitable for all investors. Always consult a licensed investment advisor or advisory firm from SEBON before considering any advanced trading strategies. Market conditions can change rapidly.

Article By: Rasbin Pandey