What Is Short Selling? The Whole Concept Explained
There is always this question for a newbie retail trader, how do we profit from the stock that is bearish (falling down)?
The answer is Short Selling. Now, what exactly is short selling?
The whole concept is very simple, when the market is falling or is bearish according to your views, you first sell it then buy it.
However, in the normal case, you just buy the stock and sell it later right. In short selling, its completely opposite.
However, there are downside to Short Selling.
Downsides of Short Selling
- In short selling, you first sell it at a higher price and then buy it at a lower price.
- Selling it first simply means, you’re borrowing some shares which are not yours from the open market and sell them first and later buy them at lower prices to make profits.
- Therefore, short selling can’t be applied to holding and you can short sell only on an intraday basis.
Benefits of Short Selling
- The benefits are rather defined. The only benefit of short selling is that, you can make profits from the falling or bearish market.
What If I Have Long Bearish View On Market And Willing To Hold The Trade Longer Than Just A Day?
This is where the Futures & Options comes in. Futures and Options are derivative products. They are derivatives because their value is based on the underlying asset such as Gold price in case of Gold Futures.
However the risk involved in the Futures & Options are much higher than trading normal stocks.
I have explained Options Trading In India For Beginners on my other blog. You can read it out to completely understand the factor behind the options and how they work.
Let’s discuss a bit more about holding a short position for a longer time.
Normally with short selling stocks, it is not possible to hold a short position for more than a day. You have to close your trade on an intraday basis. This is because you simply don’t own the shares you sell in the market, you borrow them from the lenders in the open market while selling and you have to return them before the market closes.
Now, where does these lenders come from?
Yes, that’s quite simple. There are many people who are holding stocks in their main long portfolio right?
They sometimes need margin or earn money on the portfolio of shares they hold, so they decide to pledge the shares they hold.
Once they pledge the shares, the broker can use it to lend these shares to the Short Sellers out there in the open market. This is how short selling is made possible.
Back to our original heading, how can we hold a short trade for longer than a day?
Futures: Holding The Short Trade For Longer Term
Yes, futures and as well as Options make it possible to carry the short position over the long term.
Futures contracts are the legal agreement to buy or sell at a predetermined price at a specified time in the future.
Option contracts on the other hand, gives it owner, or holder, the right, but not obligation to buy or sell an underlying asset at a specified strike price on prior or spiecified date.
Let me explain in layman terms,
Futures In Simple Language
Future is a type of agreement where you make it to buy or sell a stock in lots on a specific date and price.
Here in the futures market_, you can’t buy a single share or shares as per your wish. The **Lot Size of Particular stocks is predetermined.**_ **You need to pay for the whole shares in a lot as per the current stock price.**
To know the lot sizes of stocks, please visit here.
I am bearish on Infosys and my views are that by the end of May 2021, the shares of Infosys might trade at Rs 1200. Therefore, I short sell a futures contract in the future market and hold it till the next expiry or the end of the month’s Thursday (expiry day of contract).
If the price of Infosys fell I make profits and at the end of the contract, you need to buy the stocks at a determined price or you can also transfer this contract to others by just squaring off your position.
Options In Simple Language
In futures, we saw that, you need to pay the whole shares in the lot as per the stock current price. However in the options, you don’t pay for the whole shares in the lot as per the stock current price instead you pay the premium.
This premium is decided on many factors which we don’t need to understand for now but this premium is much lesser than the current stock price. Therefore a lot costs very less compared to the futures.
There are two types of Options, Call (CE) & Put (PE).
Call (CE) is purchased when you’re bullish on the stock and Put (PE) is purchased when you’re bearish on the stock. There are different strike prices and you need to pick your closest view of the strike price.
I am bearish on Infosys and expect it to be Rs 1200 by the end of May 2021. I will go ahead and buy the Put (PE) of strike price 1200 since I have bearish view, and hold it till expiry to benefit of the falling price of Infosys.
Similar to the future, this contract also expires monthly. The last Thursday of every month is the expiry. On the expiry it’s the same, you either need to buy the whole lot by paying the amount at a specified strike price.
I hope you have an idea of what exactly is the Short Selling and how you can also carry forward this short trades for longer than one trading day.
If you’re new to market, it will definitely take time to learn things and these things can be pretty confusing to beginners but over the time, as soon as you learn, everything will seem easy.
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