Shorting or Short Selling in Futures Market – Know Everything

Know about Short Selling in Futures Market or Shorting in Futures Trading here.

A simple example of a profitable transaction would give one the idea about selling anything over and above its original cost. This is how most financial transactions are structured.

Be it an equity stock or a real estate property, if an investor aims to make a profit through them, they would ideally proceed to purchase the asset at a low price first.

This would involve a generous and detailed assessment of the market conditions and making estimates about the viability of the asset.

Moreover, the investor would need to take a directional view on the asset and estimate its expected price movements.

Only then, they would buy it at a given price. Later, after a certain number of days, months and even years, they will sell it.

Selling the asset will lead to the realization of a profit, which will hopefully be a return more than the buying price of the asset.

This is how most transactions take place if an investor wants to make a profit out of them. However, in the case of shorting or short selling, the opposite of this happens.

About Short Selling or Shorting

In Short Selling, an investor first sells a security and then proceeds to buy it at a later date. Thus, shorting is the complete opposite of the traditional direction of a financial transaction.

The vital question that emerges at this point is, why an investor would deem to sell security first! This is quite simple to answer.

Any investor purchases a security with the expectation that it will rise in price in the future. Then, he sells it at a later date to realize profit out of it.

In an analogous manner, an investor would usually sell security first if they expect that the price of it will fall down in the days to come.

When an investor takes a directional view that the price of a security will increase, he is ‘long’ on that stock.

At the same time, if the investor expects that the price of a security will fall down in the days to come, he is ‘short’ on such stock.

In the stock market, it is possible to make money from an underlying security, no matter which direction it moves in.

The investor only needs to have a directional view on this price movement and take a position accordingly.

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How does Shorting take place in the Futures Market?

In the futures market, there is no restriction on shorting like the spot market. Due to this element of the futures market, traders find it really attractive to place their trades in the futures market.

As we have already discussed in the previous articles, a future is a derivative which derives its price from the value of an underlying asset. If the value of an asset is falling, its impact will also put an impact on the price of its futures.

This possibility opens the scope to enter into a future trade for security, for which you have a bearish outlook.

Same as a long position, even a short position will require a deposit of a margin amount. The difference between long and short positions do not impact the quantum of margins.

Example on Short Selling in Futures Trading

Let us take an example to better understand the concept of short selling or shorting in futures market. Let us assume the same security, ABC, as in the above example.

You plan to take a short position in ABC at a price of INR 1990. The minimum lot size for this stock is 125.

Over the next few days, ABC moves in the following manner:

Day 1: You short the stock at INR 1990. The reference price for M2M will remain INR 1990. Today, the stock closes at INR 1982. For this day, your profit will be 125 * 8 = 1000.

Day 2: The reference price for M2M will remain INR 1982. Today, the stock closes at INR 1975. For this day, your profit will be 125 * 7 = 875.

Day 3: The reference price for M2M will remain INR 1975. Today, the stock closes at INR 1980. For this day, your loss will be 125 * 5 = 625.

Day 4: The reference price for M2M will remain INR 1980. Today, the stock closes at INR 1989. For this day, your loss will be 125 * 9 = 1125.

Day 5: The reference price for M2M will remain INR 1989. Today, the stock closes at INR 1970. For this day, your profit will be 125 * 19 = 2375.

Day 6: On this day, you decide to square off the stock. The reference price for M2M will remain INR 1970. Today, the stock closes at INR 1965. For this day, your profit will be 125 * 5 = 625.

The total profit or loss resulting from this trade will be = 1000 + 875 – 625 – 1125 + 2375 + 625

This will amount to a total profit of INR 3125.

The same calculation is also possible this way: 1990 – 1965 multiplied by the lot size.

In this way, you would have understood that taking a short position in the futures trade is the same as a long position. The margin and M2M remain the same here as well.

Learn everything about Futures Trading

How to take a Short Position in the Spot Market?

When we consider the spot market, there is a restriction on short trading which every trader must follow.

Unlike taking delivery of stocks, and holding them for as long as needed, a short position can only be taken in intraday trade.

This means that the investor will have to settle the trade on the same day as they enter it. In the case of short selling, this means buying back the stocks on the same day as they are sold on.

It is not possible to carry forward a short position. The exchange has a good reason to put this mandate.

Mandate put on by the Stock Exchanges

For the stock market exchange, there is no difference between a short selling on an intraday basis and delivery basis.

According to them, when you take a short position, all they understand is that you have sold stocks.

To complete the trade, you will also need the stocks on the next trading day to settle the transaction. But that cannot happen, since you do not really have possession of the stocks.

What will happen next is that you will fail to deliver the stocks and make a default which will impose a hefty penalty on you.

This is why the exchange does not allow you to carry forward a short position to the next day. Thus, if you decide to take a short position in the spot market, you will have to settle the trade on the very same day.

Sometimes, a penalty as high as 20% can be imposed by the stock exchange. It is charged on the short price with which the trader enters the trade.

This is why shorting in the spot market closes on the same day. Since both sides of the transaction are made on the same day, there is nothing really to settle down at the end of the trading day.

But this does not mean that you will not be able to carry forward a short position in the futures market.

How to Short Sell a stock in the Spot Market?

Before proceeding to the futures market and understand how shorting takes place, it is vital to understand the same for the spot market. Taking an example will help you understand the concept clearer.

Let us suppose that as a trader, you look at various charts for stock ABC. According to your estimates, you form the opinion that the stock will fall down in the days to come.

Various parameters of the study show that your bearish outlook towards the stock may be right. To be sure, you try to put down your estimates in numerical terms and form the opinion that ABC will fall by a minimum of 2% in the days to come.

Thus, you decide to enter into a short trade of ABC and take an intraday position in the stock. Let us say that the price at which you assume the short position is INR 1990.

You expect that the stock may fall down to INR 1950. The total number of shares which you decide to trade in is 50.

Using Stop Loss

To be on the safe side, you assume a stop loss of INR 2000. Thus, it is clear that you expose yourself to a risk of INR 10 and a reward of INR 40, should your estimates prove to be right. A mound of profits waits for you, should the stock indeed fall down up to your expected price level.

Depending on the functionality of your stock trading platform, you will be able to select the option to sell the stock. Choose the price at which you will like to enter the trade and enter the quantity for which you want to trade.

Doing so will open you to a short position in stock ABC. As expected, you will incur a loss only if the price of the stock ABC moves in a direction against your expectation.

Shorting a stock means that you expect it to move downwards. Thus, you might incur a loss on the trade, if the price of the stock moves upwards. This is why the stop loss is a price higher than the price at which you take a short position.

As a result, to the above trade, you can expect two different scenarios to materialize as a result of your position.

The Stock Price may come down to INR 1950

This is a clear indication that the directional view of the trader was indeed correct. Now, you may close the trade since you have met your target. In this situation, you will sell the stock at INR 1990 and buy it at INR 1950.

Due to this difference, you will make a profit of INR 40 on each stock at the end of this trade. The facts of the trade remain the same.

You have essentially bought the stock at a low price and sold it at a price higher than that. The order of the transaction is the only thing which is different here.

The Stock Price can increase to INR 2000

Unfortunately, in this case, the directional view you had for ABC did not turn out to be correct. To make a profit, you needed the price of the security to go down instead of going up.

Since in this case, the opposite is happening, it is clear that you will not be coming out of this trade making a profit.

Recall that you took a short position in ABC at INR 1990. You expected that the price of the security ABC will come down.

Now, the opposite of that is happening and the stock stands at INR 2000. This is the price at which you had set a stop loss as well.

Now, you could wait for the price to fall down again but there is also a huge chance that the price of the stock will only increase in the time to come.

Perhaps it is better to book your loss and exit from the position instead of waiting around for the stock price to make a rebound.

Since you will be buying the stock at INR 2000, you will incur a loss of INR 10 per share. Once again, in this loss making transaction, it is clear that you took a short position first and then sold the stock.

It is as good as buying a stock at a price but selling it at a price lower than that. Only the order of the transaction is reversed.

To Conclude Shorting in Futures Trading

The idea behind short selling relates to selling a stock before buying it.

Profit, in this case, happens only when the stock moves down in price after taking a short position. If the opposite of this happens, the trader will incur a loss.

In the spot market, a trader can only short on an intraday trade. But in the futures market, this is not the case.

When it comes to the futures market, the trading requirement for shorting a stock is the same as a long position.

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