You must be wondering if short selling can also be carried out in futures. The biggest advantage of trading in futures is that you can short-sell without having the stock, and you can carry forward your position.
Shorting is a concept that cannot be easily implemented by all, because it is not an everyday normal transaction. Short Selling lets an investor sell a security without having to own it and then buy it at a later date. Thus, shorting is an exact opposite concept of the traditional financial transaction.
You must now wonder that, “Why would an investor sell a security even before buying it?”
Any investor purchases a security hoping that its the prices will rise in the future. And, sells it later to make profit out of it. 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 analyses that the price of a security will increase, i.e. move in an upwards direction, he is ‘long’ on that stock. On the other hand, if the investor analyses a fall in the prices of the security, he is ‘short’ on such stock.
The stock market is such a vast pool of opportunities and possibilities that makes possible for an investor to earn money, no matter which direction the market moves in. The investor only needs to have a directional view on this price movement and take a position accordingly.
How does Shorting stocks work
We need to understand how shorting works in the spot market. When one shorts a stock or stock futures, the expectation is that the stock price goes down and therefore one can profit out of the falling prices.
But the key question is when to short sell a stock. There are 2 ways - You can either do short selling in spot market or you can do short selling in futures market.
Firstly, you can actually short sell in the cash market. Here, you can only short sell intraday. When you are selling in the spot market, your selling time span is limited to just one day. However, price movement may not happen on the same day and that means you will have to close the position at a loss.
That means if you sell a stock in the morning and you cannot give delivery then you will need to mandatorily cover your position (buy it back) before end of trade on the same day. As you know, Indian markets operate on T+2 rolling settlements. So, if you do not square up your positions on the same day then these stocks will automatically result in delivery.
Consecutively, if you have sold in the morning and not bought it back by evening then you need to give delivery of the stock.
Another option is to sell the stock in futures. 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.
On the trading platform when you are required to short, all you need to do is highlight the stock (or futures contract) you wish to short and press F2 on your trading platform. By doing this, you can sell the order form; enter the quantity and other details before you hit Submit. When you hit submit, the order hits the exchange and assuming it gets filled, you would have created a short open position for yourself.
When you enter a trading position, under what circumstances would you make a loss? Well, quite obviously you would lose money when the stock price goes against your expected direction. So,
· When you short a stock what is the expected directional move?
· The expectation is that the stock price would decline, so the directional view is downwards
· So when would you start making a loss?
· When the stock moves against the expected direction
· And what would that be?
This means you will start making a loss if the stock price instead of going down starts to move up
For this reason whenever you short, the stoploss price is always higher than the price at which you have shorted the stock. However, it’s a point to remember that when you short, you make money when the price goes down and you lose when the price increases.
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.
To help you understand the ‘Mark to Market’ (M2M) perspective when you short futures, let us take up the following example. Imagine you have shorted HCL Technologies Limited at Rs.1990/-. The lot size is 125. The table below shows the stock price movement over the next few days and the respective M2M –
The two lines marked in red highlights 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
Alternatively, we could look at it as –
(Selling Price – Buying price) * Lot Size
= (1990 – 1965) * 125
So, shorting futures is very similar to initiating a long futures position, except that when you short you profit only if the price declines. Besides this, the margin requirement and the M2M calculation remains the same.
Shorting is a very integral part of active trading. I would suggest you get as comfortable with initiating a short trade as you would with a long trade.
Let’s understand Short Selling in Futures Trading Practically
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.
As short selling might appear to be a simple method, if you have a negative view on a stock it may be a better choice for you to sell in futures. The major advantage of selling in futures is that you can not only sell stocks but you can also sell indices like the Nifty and Bank Nifty. So you can take a directional view on a sector or the market and play through indices. Short selling in the spot market does not offer this facility. Selling in the spot market has certain disadvantages, and hence selling in futures remains a better option!