Let me start this article from where I left in my previous article of this module. In the last article, I have discussed on futures trading. We have seen that stock futures can be bought. But an obvious question arises wherefrom the seller is selling. Futures are not stocks and the seller does not have the possession of the stock. So where from he is selling? So in this article, I will discuss what is short selling. I will describe shorting of stocks and futures with the short selling example.
So the buyer of a stock or future always can say that I want to buy this stock or future as I know the price of the same may go up. But wherefrom the seller is selling when he doesn’t have any possession? But a seller can also do so in future. Only in future trading, someone can sell a stock future or an index future even if he or she doesn’t have a possession. This is what is short selling or in simple terms “shorting”. Many times you have read in the newspaper or heard on the TV that shorting is going on or shorts are created in the market or short covering is going on, so you now have the answer.
So in simple terms what is short selling can be answered as someone is selling you a stock future at some price what he does not possess. So it is a risky way to profit from the declining stock prices. You can only do this in the stock futures market, nowhere else. Shorting is also possible in the intraday cash market as well. Very important point to remember that in cash market, shorting is possible in only in intraday trading, not in delivery trading. When we buy a stock or future we expect the price to go up. On the other hand, when we short a stock we expect the price to go down. Shorting of a stock or future is the inverse of buying it.
Let’s discuss a short selling example. Suppose, Ramu owns a property worth Rs. 10 Lacs. Ravi wants to buy the property but he did not know the owner. So he approached a broker named Roshan, who does not own the property, still, he assures Ravi that he can sell the property. Roshan knew the property price is Rs. 10 Lacs. So he asks Ravi to pay Rs. 15 Lacs. Ravi bargains that he can pay only 13 Lacs. Roshan agrees on the deal and he makes a contract that he will sell the property at Rs. 13 Lacs after a pre-fixed time. Now Roshan can Pay Rs. 10 Lacs to the property owner Ramu and hand over the property to Ravi who is paying him Rs. 13 Lacs. So this extra 3 Lacs is the profit of Ravi. And this is what is short selling.
Now let’s discuss a short selling example of the stock market. Ravi has heard that Bajaj Auto is in financial trouble and he expects the stock price to go down intraday. In order to profit from his analysis, Ravi will now short Bajaj Auto. So Ravi opens up his broker’s terminal, say Zerodha Kite and opens up a short sell order for 100 quantities in MIS.
Now the order management system of the broker and the stock exchange will automatically find the stock in stock inventory as well as in the client’s portfolios. Say Ravi’s broker Zerodha, find Bajaj Auto stock in one of their client’s portfolio and borrows it. The broker will now sell the share on the market for Ravi. Say the sell order gets executed at the price of Rs. 3240. The stock will temporarily be credited to Ravi’s trading account.
Ravi was right, after 2 hours Bajaj Auto’s share price drops to Rs. 3100. Because the stock price has dropped, Ravi can now make a profit by buying back the stock or covering the short. So he now opens up a buy order in MIS and suppose the order gets executed at Rs. 3100. The broker will use the money from Ravi’s trading account to buy 100 shares of Bajaj Auto. So Ravi sells the stock at Rs. 3240 and buys it back at Rs. 3100. So he makes a profit of Rs. 3240 – Rs. 3100 = Rs. 140. His net profit is Rs. 140 x 100 shares = Rs. 14000. Ravi has to pay the broker the margin money for the right to borrow the stock.
So we have discussed what is short selling and we have also seen short selling example. It should be practiced only by advanced traders as it is extremely risky. Unlike buying a stock or going long, where your losses are limited, your losses can be unlimited when you short. Why risk is unlimited can be explained by price versus profit graph. Suppose you bought a stock worth Rs. 100, the maximum loss that can be is Rs. 100. If the stock price goes up, your profits will continue to go up as well. Here actually there is no limit how high the price can go.
Now consider you have shorted the same stock at Rs. 100. In this case, you profit only when the profit decreases. Your maximum profit can be Rs. 100, i.e, the price of the stock. But if the price goes up your loss will also go up. There is no limit on how far the price of the stock can go up. So, your losses can be theoretically unlimited.
What is short selling difference between the cash market and futures market? As we already discussed that shorting can be done in intraday cash market as well as in futures market. In intraday cash market the cover of short is to be done on the same day as we saw in our short selling example. But in the futures market, the short can be covered on or any time before the expiry date. Till the time, the short is covered in the futures market, the margins will remain blocked and MTM settlements will be done regularly in the trading account.
Indrajit is a professional blogger and trading system developer. Amibroker expert, Wordpress expert, SEO expert and stock market analyst.Trading since 2002, he has started the journey of StockManiacs.net on 2008. He follows Indian and world stock markets closely.