Short Selling understanding what is shorting with examples

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Generally, since most of our day to day exchanges involve buying first and selling later, at an extra cost or a loss, comprehending the concept of shorting can be tricky. To illustrate the point – say we bought an apartment for Rs.X and sold it two years later for Rs.X+Y; the profit made was Rs.Y, which is easily understandable. But when it comes to shorting, we sell first and buy afterwards, reversing the process completely.

It is straightforward to understand why a trader would opt to buy or sell a stock first and then purchase it later; when we think the cost of an asset will appreciate, buying it means we can take advantage of that increase. Conversely, if we predict a decrease in its value, selling it off before then enables us to reap the benefits of that fall!

Didn’t understand the concept? Let me give you an analogy. Thinking of your friend and yourself watching a nail-biting cricket match between India and Pakistan. You bet that India will win and your friend wagers it will lose. 

This would result in you making money if India comes out on top, while your companion would be richer if they don’t. Taking this example into consideration, imagine the Indian cricket team is a stock trading in the stock market – with your prediction being equivalent to an investment in the stock going up (India winning) and your pal’s forecast being similar to investing when the stock goes down (India losing). To summarise, you are ‘long’ on India while they are ‘short’ on India.

Are you still feeling unsure? You may have some lingering questions on your mind. The vital thing to remember about shorting is that if you expect the stock price to decrease, you can make money by selling the shares first and buying back later. The best way to learn how it works is through practical experience, but fortunately I’ll be covering all the basics in this chapter.

– Shorting stocks in the spot market

In order to comprehend the concept of shorting a stock in the futures market, it is essential to be familiar with how the process works in the spot market. To illustrate this, let’s imagine a hypothetical example –

  1. A trader looks at the daily chart of HCL Technologies Limited and identifies the formation of a bearish Marubuzo
  2. Along with the bearish Marubuzo, other checklist items (as discussed in TA module) comply as well
    1. Above average volumes
    2. Presence of the resistance level
    3. Indicators confirm
    4. The Risk & Reward ratio is satisfactory
  3. Based on the analysis the trader is convinced that HCL Technologies will decline by at least 2.0% the following day

The trader sees the stock’s price will go down and wants to take advantage of this. So, he short-sells it. To gain a better understanding, let us define the move:

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We can see from the table above that shorting the stock at Rs.1990 is a profitable strategy, as the expectation is that the stock price will decline, providing an opportunity for profit.

When trading, selecting the stock (or futures contract) and pressing F2 calls up the sell order form. Input the quantity and other specifications before sending your request. Once you hit Submit, it will direct to the exchange, creating a short open position if filled.

When you enter a trading position, what could lead to a loss? It is clear that if the stock price moves in the opposite direction compared to your expectations, you would end up with a financial loss.

  1. When you short a stock what is the expected directional move?
    1. The expectation is that the stock price would decline, so the directional view is downwards
  2. So when would you start making a loss?
    1. When the stock moves against the expected direction
  3. And what would that be?
    1. This means you will start making a loss if the stock price instead of going down starts to move up

Whenever you short sell, the stoploss price is set at a higher level than the stock’s entry cost. As seen in the table above, this trade was entered at Rs.1990/- and has a stoploss of Rs.2000/-, representing an increase of Rs.10/- from purchase price.

Let us take a look at two possibilities if we begin a short trade at Rs. 1990/-. Hypothetically, we can explore what might happen.

Scenario 1 – The stock price hits the target of Rs.1950/-

In this instance, the stock has dropped from Rs.1990/- to Rs.1950/-, achieving the desired outcome and necessitating the trader to close the position. As is standard in such cases, a short position requires closure.

  1. First sell @ Rs.1990/- and
  2. Later buy @ Rs.1950/-

Overall, the trader would have gained Rs. 40 from the transaction as the cost to purchase was Rs. 1950 and the selling price was Rs. 1990.

From a different perspective, the same effect can be achieved as if buying at Rs.1950 and then selling at Rs.1990. The only difference is that the order of the transaction has been reversed – instead of purchasing first and then reselling, the individual sold first followed by buying.

Scenario 2 – The stock price increases to Rs.2000/-

In this instance, the stock price has surpassed the short value of Rs.1990/-. Remember, to make a profit from shorting, the stock must decrease in value. As the price has increased here, it will result in a loss.

  1. The trader shorted @ Rs.1990/-. After shorting, the stock went up as opposed to the trader’s expectation
  2. The stock hits Rs.2000/- and triggers the stoploss. To prevent further losses, the trader will have to close the position by buying the stock back.

The trader will take a hit of Rs.10/- (2000 – 1990) throughout this transaction. If you consider the standard buy-first-sell-later approach, this means buying in at Rs.2000/- and selling out at Rs.1990/, and if we switch the order, it’s then sell-first-buy-later.

Hopefully the above examples have convinced you that with shorting, you gain when the price goes down and lose when it goes up.