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All about Shorting

learning sharks stock market institute

Forward Market

• Forwards market
• Futures contract
• Future trades
• Leverage & payoff
• Margin & M2M
• Margin calculator
• Open interest

• How to short
• Nifty futures
• Nifty futures
• Futures pricing
• Hedging with futures
• Notes

8.1 – Shorting in a nutshell

Shorting was briefly covered in Module 1. However, we shall examine shorting in more detail in this chapter. Because we don’t typically short things in our day-to-day transactions, shorting is a difficult idea to understand. Imagine this transaction, for instance:

Let’s imagine you purchased an apartment today for Rs. X and sell it for Rs. X+Y two years later. The added value above and above Rs. X, which just so happens to be Rs. Y is the transaction’s profit. This transaction is straightforward to understand and uncomplicated. In fact, the majority of daily transactions call for us to first buy something before later selling it (maybe for a profit or a loss). We are  to these straightforward transactions. However, when doing a short sale or simply “shorting,” we carry out the transactions in reverse, i.e., sell first and buy later.

So what would force a trader to first sell something before later buying it? Well, it’s actually fairly straightforward: When we anticipate that the price of an item, like a stock, would rise, we buy the stock first and sell it later. However, we typically sell the stock first and then buy it later if we think its price will decrease.

Confused? In order for you to grasp the basic idea at this point, let me try to give you a crude comparison. Consider that you and your friend are watching a thrilling India-Pakistan cricket match. You two are in the mood for a quick wager. Your friend bets that India will lose the game, while you wager that India will win. Naturally, this implies that you profit if India triumphs. Likewise, if India lost the game, your friend would profit.

For the time being, imagine India (in this context, the Indian cricket team) as a company that trades on the stock exchange. When you do this, your wager is the same as saying that you will profit if the stock increases (India wins the game) and your friend will profit if the stock decreases (India loses the match). According to market jargon, you are long India while your friend is short the country.

Still, perplexed? Perhaps not, but there are probably a few unsolved questions niggling at the back of your mind. Just keep in mind this one thing for the time being if you are brand new to shorting stocks: whenever you believe a stock’s price is about to decrease, By selling the stock short, you can profit. You must sell your stock or futures initially and then purchase them back later to short them. In actuality, the P&L of actually shorting a stock or pair of futures is the best method to understand how to short. However, I’ll try to cover everything you should know in this chapter before you short stocks or futures.

8.2 – Shorting stocks in the spot market

Prior to learning how to short a stock in the futures market, it is important to comprehend how shorting operates in the spot market. Consider the following fictitious circumstance:

  1. A trader notices the formation of a bearish Marubuzo on HCL Technologies Limited’s daily chart.
  2. Other checkpoints on the checklist (covered in the TA module) comply in addition to the bearish Marubuzo.

1. higher than normal volume

2. the resistance level is present

3. Manifestations support

4. The risk-to-reward ratio is acceptable.

3. The trader believes HCL Technologies will decrease by at least 2.0% the following day as a result of the analysis.

The trader now hopes to profit from the  price fall in light of this view. He decides to short the stock as a result.

As is common knowledge, when one shorts a stock or stock futures, they anticipate that the stock price will decline and that they would be able to profit from the decline in value. The goal is to short the stock at Rs. 1990 based on the table above.

You only need to highlight the stock (or a futures contract) you want to short on your trading platform and press F2 when you have to short it. By doing this, the sell order form is . Before clicking submit, input the amount and other information. As soon as you click “Submit,” the order is sent to the exchange, and if it is filled, you will have opened a short position for yourself.

Anyway, consider this: Under what conditions would you incur a loss if you had a trading position? Naturally, you would lose money if the stock price moved in the opposite direction of what you had . So,

1. What way should a stock move in if you short it?

  1. The directional view is downward since it is that the stock price will decrease.

2. So when would you begin to lose money?

  1. when the stock moves counter to expectations

3. What would that be, then?

  1. This indicates that if the stock price begins to rise rather than decline, you will begin to lose money.

The stop loss price is always greater than the price at which you have shorted the stock whenever you have a short position. So, as you can see from the table above, the short trade entry price is Rs.1990, and the stop loss price is Rs.2000, which is Rs.10 more than the entrance price.

After starting the short trade at Rs.1990/-, let’s now speculatively consider two possible outcomes.

Situation 1: The stock price reaches the desired level of Rs.1950.

In this instance, the stock movement matched expectations. The stock price decreased from Rs. 1990 to Rs. 1950. The trader is  to close the position since the aim has been met. As is well known, in a short position, the trader must:

  1. initial sale at Rs. 1990, and
  2. Later purchase at Rs.1950

The merchant would have earned a profit throughout the entire procedure equivalent to the difference between the selling and buying prices, or Rs. 40/- (1990 – 1950).

If you approach it from a different perspective, such as the typical purchase first and sell later perspective, this is just as advantageous as purchasing at Rs. 1950 and selling at Rs. Just that the trader’s order of transactions has been flipped, with sales coming first and purchases coming last.

Scenario 2: The stock price rises to 2000 rupees.

In this instance, the stock price has risen over the Rs. 1990/- short price. Keep in mind that if you short a stock, the price must fall for you to profit. A loss would result if the stock price increased in place of falling. In this instance, the stock has increased, hence there will be a loss.

  1. The trader made a short sale for Rs.1990. The stock increased after being shorted, contrary to the trader’s anticipation.
  2. When the stock reaches Rs. 2000, the stop loss is triggered. The trader must finish the position by repurchasing the stock in order to stop further losses.

The trader would have lost Rs. 10 over the entire procedure (2000 – 1990). This transaction is equivalent to buying at Rs. 2000 and selling at Rs. 1990, if you approach it from the traditional buy first, sell later perspective. Likewise, if we reverse the sequence, it would be sold first and purchased later.

Hopefully, the two examples above have convinced you that when you short something, you profit when the price declines and lose money when the price rises.

8.3 – Shorting in spot (The stock exchange’s perspective)

One restriction applies to shorting in the spot market: it must be  exclusively intraday. The short transaction can be  at any moment during the day, but you must purchase back the shares (square off) before the market closes. The short position cannot be  over for a number of days. We must comprehend how the exchange handles the short position in order to comprehend why shorting in the spot market is purely an intraday activity.

Recall the discussion from above occasionally. Let’s imagine for a moment that you have shorted stock with the anticipation of profiting from the price decrease. You decide to wait another day because the price has not dropped as much as you had hoped after you shorted it. However, the exchange would determine at the end of the day that you had sold shares during the day, so you would need to retain these shares available for delivery.

However, you cannot fulfill your delivery commitment with these shares. This indicates that you will break your responsibility, which will result in a severe penalty. This circumstance is also known as “Short Delivery.”

In the event of short delivery, the exchange would raise the matter and resolve it in the auction market. You should read this Z-Connect article, which outlines the auction market procedures and how a client is penalized for failing to meet a delivery commitment. Here’s some advice: never engage in “short delivery” transactions, and always terminate your short trades before the market closes to avoid penalties that might be as much as 20% above your short price.

This also brings up a crucial point: the exchange already checks for commitments after the market ends. Therefore, if one were to cover the short position (by squaring off), there would be no obligation at all at the end of the day before the exchange can perform the “obligation check.” So, in order to avoid actually bringing forward the delivery obligation, shorting in the spot market must be  exclusively as an intraday trade.

Does that imply that all short positions must be settled by the end of the day? Actually, no. In the futures market, a short position can be maintained overnight.

8.4 – Shorting in the Futures Market

Shorting a stock in the futures segment has no restrictions like shorting the stock in the spot market. In fact this is one of the main reasons why trading in futures is so popular. Remember the ‘futures’ is a derivative instrument that just mimics the movement of its respective underlying. So if the underlying value is going down, so would the futures. This means if you are bearish about a stock then you can initiate a short position on its futures and hold on to the position overnight.

 

Similar to depositing a margin while initiating a long position, the short position also would require a margin deposit. The margins are similar for both the long and short positions and they do not really change.

 

Let’s use the following example to better illustrate the “Mark to Market” (M2M) perspective while shorting futures. Assume you sold a short position in HCL Technologies Limited at Rs. 1990. Lot dimensions are 125.

 

The two lines marked in red highlight the fact that they are loss-making days. To get the overall profitability of the trade we could just add up all the M2M values –

 

+ 1000 + 875 – 625 – 1125 + 2375 + 625

= Rs.3125/-

 

Alternatively, we could look at it as –

 

(Selling Price – Buying price) * Lot Size

 

= (1990 – 1965) * 125

= 25*125

=Rs.3125/-

 

Therefore, starting a long futures position and shorting futures are quite similar, with the exception that when you short, you only make money if the price drops. In addition, the M2M calculation and the margin need are unchanged.

 

Active trading involves a significant amount of shorting. You should become as confident starting a short trade as you would starting a long one, in my opinion.

CONCLUSION

  1. When shorting, we must sell first and then buy.
  2. Only when the closing price is lower than the entry price is a short trade profitable.
  3. A loss occurs when the price rises above the level at which one has shorted it.
  4. When trading short, the stop loss is always set higher than the price at which the trade was initiated.
  5. In the spot market, only intraday shorting is permitted.
  6. In the spot market, the short positions cannot be maintained overnight.
  7. The futures market allows for the overnight carrying forward of short positions.
  8. The margin requirement is the same for long and short trades.
  9. Both short and long trades use a similar M2M algorithm.