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What is Short Selling and How Does It Work

Short selling is a technique of stock trading, different from conventional trading. As a market trader, you should know what does shorting a stock mean. How does short selling work.

Before we learn what is shorting, let us have some idea how you make money by trading.

You find that stock market is going to rise in near future. You have chosen a stock for trading. Your research says that the stock is going to move higher in near future.

You buy that stock at current market price. Then you wait for the stock to rise. The stock moves higher and you sell it at higher price. The difference between your selling price and buying price is your profit (excluding brokerage charges). That is really simple.

When you buy a stock, it is called ‘Going Long’. You can keep your stocks for long term investments or short term trading. This is known as ‘Long Position’

But the stock markets and the stocks do not move in a straight line. If they go up, they come down too. Sometimes, market falls are more prolonged with no significant up moves.

What would you do at that time? Would you keep waiting for the markets and stocks to start moving higher and then start trading? Would not that be a wastage of your time and trading opportunities in the stock market?

Would not that be great if you could utilize market falls or stock price falls for making money in declines too?

Yes, you can do that. You can make falls in stock prices to work for you. This is where shorting a stock or short selling comes into play.

Selling a stock you do not own and have borrowed from your broker and later on buying back that stock is called short selling, shorting or ‘Going Short’.

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 may be confusing for you.

Professional traders use shorting for various purposes. It can be purely trading to make money in falling markets or to protect their long term stock portfolios from fall in stock prices.

We shall find out how does short selling work to create more trading opportunities for you.

Short Selling : What Does Shorting A Stock Mean

Short Selling or Shorting 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.

Shorting can be done for any security; it can be stocks, currencies or commodities. We shall be talking about shorting a stock for understanding purposes.

A short seller borrows stocks from the broker. He will sell these stocks to a buyer in the stock market at prevailing current market price. This creates his trading position in the market.

The short seller then waits for the stock to fall. When the stock price falls, he will buy back those stocks and return them to the broker. Thus his trading position is closed.

The difference between the selling price and buying price is the profit of the short seller.

How Does Short Selling Work?

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.

Learn what is margin trading and how it can multiply your profits.

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.

Let us understand stock shorting with an example :

Suppose a stock XYZ is trading at $100. You expect the stock price to fall towards, say, $95. You will simply go for shorting this stock.

If the stock declines to ,say, $95. You can buy back the stock by squaring off your position to exit the market.Your profit is $100 – 95 = $5 per stock.

Short Selling

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.

There are different opinions regarding short selling. Some people consider it illegal. This is because the short seller are betting on falls in stock prices. Falls in stock prices indicates profit of the companies as well business going down. So they want a ban on short selling.

But there are advocates for short selling too. They are of the opinion that short selling keeps stock prices in check. It adds versatility to trading and allows money making in market downfalls too.

Whatsoever their opinions, it should be remembered that short selling is highly risky.

We took an example of shorting a stock above. To the maximum, this stock can fall to zero. So maximum profit you can make by short selling this stock is $500.

Contrary to it, the stock an rise to any value if there is any sudden big positive news. It can go to 1000, 1500, 2000, 5000 or infinity. Those are the losses you are exposed to because rise in stock price is a loss for short seller.

So, theoretically , you are exposed to unlimited risk with limited profit potentials.

I am not saying that you should not go for short selling. With stop loss in place, you are very much protected.

It can happen with overnight positions when you carry home your short position to next trading days. Anything can happen in the stock market. It is a stock market. it can happen with long position too.

But with proper planning and trade management, you can go for short selling to make handsome money in falling markets too.

How To Short A Stock?

You can not short sell a stock in cash segment. This is done in margin segment. All trading accounts offer you trading in cash as well as margin. So you do not need a separate account.

With margin trading, though you can hold your trading position for more than one day for a buy order, this is not possible with short selling. Shorting in margin can be done in intraday trading only.

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. Hence, experts advise that short selling be done by professional people only.

You can short a stock by three methods –

1. Margin Trading

2. Futures Trading

3. Options Trading

Short selling in Margin Segment

As we talked earlier, you can short a stock in margin segment in intraday only.

Learn what is intraday trading and how to short sell in intraday trading.

Steps to short sell :-

1. Choose a stock which is weak on technical charts. A weak stock is the one which is in downtrend making new lows. There is no or negligible strength in the stock price.

2. Login to your trading account.

3. Find the Equity section there and look for an option to ‘Place an Order’ or ‘Sell in Margin’.

4. Enter the stock code you want to short, number of stocks you want to short and the price at which you want to short the stock in the relevant fields.

5. Place your sell order.

6. The order will be executed immediately if you place your order as ‘Market Order’. With ‘Limit Order’, the order is executed when current market price reaches your limit price.

7. Look for your position in the ‘Margin Position’ or ‘Open Position’ link. (They vary from broker to broker).

8. Here you will see your short position live. Place a stop loss order under the link ‘Square Off’ option.

Now your short position is live. Stop loss helps you protect your capital by limiting the losses in case stock price starts rising.

In case of short selling, your stop loss is towards higher stock price. This is because the losses will start incurring whenever the stock price moves above your selling price.

Suppose you short sell a stock at a price of $500 for lower targets of $490. Your stop loss will be above $500.

If you are ready to risk $5 per share loss for this trade, your stop loss will be placed at $505. You can not place a stop loss order without limit price. There will be option to place the limit price just above or below the ‘stop loss order’ option. Here you can enter your your limit price, say, $506.

Now, if the stock price rises towards 505, your order will be executed. So , you have limited your loss to just $5 per stock for this trade. Till the stock price does not touch $505, your position will stay live and you will wait for your lower targets.

Short Selling in Futures Trading

If you want to keep your short position for more than a day, you can opt for Futures Trading.

With Futures Trading, you can keep your short position as long as you wish, even for more than a month if you have little long term view on stock price. At the end of a contract month, you would need to roll over your position to next month contract.

To short a stock in Futures, head over to F&O or Futures&Options section in your trading account.

Look for the stock Futures you want to short by moving over to “Place order’ link.

Click on ‘Sell’ link against the Futures contract you want to short.

Place a stop loss order by following the steps we discussed above.

It is advisable to tell you that Futures Trading is very risky for your capital. You should learn the basics of Futures Trading before you go for it.

Short Selling Stocks with Options Trading

You can also short sell a stock with Options Trading. Options add more versatility to your trading arsenal.

Options are comparatively safer method to short stocks depending upon the method you choose.

There are two ways you can use Options to short a stock :-

Buy Put Option

This is the safest method to short the stocks. You will simply buy a Put Option for the stock you want to short. You can hold it for one month contract time.

The risk with Put Option is limited and profits can be unlimited. At the maximum, you can loose only the ‘Premium’ you pay to buy an Option.

Learn how to find a cheap Option to buy to reduce the losses and increase the profits.

Lets take the above example again. The stock is trading at $500. You expect the stock is likely to fall towards $490 or 480 in a day or few days. Also, you believe that the stock may not move above $505 during this time.

You can simply by a Put Option. Look for the various strikes available for that stock trading.

Suppose you found the 490 strike Put Option which is trading at a price of $10. The ‘Lot Size’ for it is suppose 100.

You can buy that Put Option for a Premium of 100 X 10 = $ 1000. If the stock falls as you expected, the Option price will start rising.

Say, the stock price falls towards $490, the Put Option price may move higher towards $15. Then you make a profit of 15 – 10 = 5 X 100 = $500.

But here is the catch. Though it is a method with limited risk but still maximum people loose money by buying Options only. The reason is the ‘Time Value’.

Read about Option Pricing to minimize your losses in Option Trading.

Sell Call Option

This is another method for shorting a stock. Here you sell a Call Option of Higher strike than the current price of the stock you want to short.

The price of a Call Option increases if the stock rises and decreases if the stock falls.

Similar to the above example in Put Option, you will choose a Call Option for the stock.

Suppose, you have a Call Option of strike 500 which is trading at $10. When the stock price falls, the price of Call Option will fall lower, say, to $5.

You sell the Call Option at 10 and buy it back at 5 with a net gain of $5. Again you make 100 X 5 = $ 500 when the stock price falls.

Learn how to make trading more profitable by Option writing or Option selling.

But, it is important to remember that with selling Options, you have unlimited risk and limited profits. Also you need higher margin amount to sell an Option than buying an Option.

In the above example, your maximum profit can be 10 X 100 = 1000 only. Because the Call Option price can not fall below 0.

Applications of Short Selling

Seasoned and professional traders or investors use short selling in many ways. The most important out of it is the protection of long term portfolios held by long term investors.

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.

They make money from stock shorting and compensate for the losses incurred to their long term portfolios with the stock market falls.

It is not easy for them to keep offloading their stocks before every fall in the market and again buy them 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 or minimal. This is done only when the expected fall is significant and not for routine corrections in the markets.

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 shorting 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 go for margin trading. Buying Put Options is a low risk high return strategy. Buying Options keeps your risk limited and returns unlimited.

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