Short selling is very well known to professional traders or people who are familiar with the stock markets to a certain extent.But if you are new to the markets and has just started trading in the markets, the idea of Short Selling becomes confusing.
You know the simple trading when you buy low and sell high and the difference between your selling price and the buying price is your profit.When you come to know of Short Selling,where first you sell the security and buy it later to earn the profits, it may keep you wondering if how it happens.
We shall find here how it helps you creating more trading opportunities if you are a new starter in trading and how you can protect your portfolio and increase your wealth if you are an investor.
What is Short Selling?
Short Selling or Shorting as it is popularly called as is the process of selling a stock which you don’t own and later on buying that stock to square off or close your position in the market.Your profit in short selling is the difference in your selling price and buying price.
The difference between normal trading and short selling is that while in normal trading you first buy a stock and then sell where as in short selling you first sell the stock and later buy it.Short Selling can be done only in margin trading which provides you cash leverage also.
Normal trading can be done in cash segment as well as margin segment where later provides you cash leverage.As Short Selling is a margin trade,you need to close your trading position the same day or 2-3 days later as per terms of your broker.
Suppose a stock is trading at $100 and you expect a fall in the price of the stock,you simply go and Short Sell the stock at current price in margin segment.If the stock declines to ,say, $98 and you don’t expect further fall you can buy the stock at $98 by squaring off your position to exit the market.Your profit is 100-98=$2.
As you are trading in margin,you can trade in bigger quantity with your available capital than otherwise in cash segment,hence your profits are also multiplied several folds.You need to take care of important thing that you can not hold your position for more than a day ( intraday ) or 2-3 days at the maximum
With the incorporation of Futures & Options in the markets,the things have been made quite easy.Futures & Options trades operate in the form of contracts which remain valid for a month.So you can hold your short position till the expiry of that contract which roughly corresponds to four weeks when you will need to square it off or roll over to next month.
So Short Selling provides you unique tool by which you can play the markets for downside also to earn the profits and you need not to keep waiting for market up move when you will initiate your trade.
In fact,Shorting has the potential to make huge money very fast when the markets are in panic and collapsing because people exit the markets very fast than buying.But you need to be very careful too when Shorting and go short only after your thorough research.
General tendency of the people in markets is to buy,so you might get caught on wrong foot if you leave any loophole.
Applications of Short Selling
As Portfolio Hedging :- Big investors who are holding large portfolios of the stocks use Short Selling to hedge their portfolios from market downside.If they anticipate any major down move in the markets,say 10-20%,they Short Sell to prevent their portfolio erosion.
It is not easy for them to keep offloading their stocks before a fall in the market and again buy when environment is cheerful.They need to keep their holdings to earn the dividends from the respective companies,to remain eligible to receive the bonuses or bonus shares otherwise the very purpose of their investment gets diluted.
They calculate the portfolio for each stock and short sell the equivalent quantity of that stock in either Futures or Options route.In case the markets fall and the portfolio erodes,they earn equivalently on their Short position.They can keep this profit with them or add more quantity of that stock with this profit.
In Nutshell,they almost loose nothing.This is done only when the expected fall is significant and not for routine corrections in the markets.
As Speculative Trading :- Speculator traders Short Sell to ride the market move on downside.It adds versatility to their trading business,They keep on spotting the opportunities.When markets go up,they take long positions.When market start falling,they go on Selling spree.
To keep your Short position alive in the market for short term,you can opt for Shorting Futures or buying Put Options.Intraday traders can also go for margin trading.Buying Put Options is a low risk high return strategy.Buying Options keep your risk limited and returns unlimited.