Understanding the "Futures Trading"

Lesson -> Let's Understand the Shorting

8.1 - In a Nutshell: Shorting

This chapter will focus on shorting. Because we aren't used to shorting in every day transactions, shorting can be a complicated concept. Imagine this: You buy an apartment for Rs.X today and then sell it for Rs.X+Y 2 years later. The incremental value above and beyond Rs.X is what makes the transaction a profit, which happens to be Rs.Y. This transaction is simple and intuitive. It is common for us to purchase something first, then sell it later (for a profit or loss). These transactions are easy to understand and are commonplace. In a short sale, or just shorting, however, the transaction is done in the opposite direction. Sell first and then buy second.

What would make a trader sell an asset first, and then purchase it later? It is simple. When we think the price of an asset, such as stock, is likely to rise we purchase it first and then sell it later. If we think the stock's price is going to fall, we sell it first, and then buy it later.

Are you confused? Let me give you an example to help you get the idea. Imagine you and your friend are watching the India Pakistan cricket match. You are both in the mood to make a wager. Your friend wagers that India will win, while you bet that India will lose. This means that you win if India wins. Your friend would also make money if India loses the match. Think of India (in this case, the Indian cricket team) as a stock trade in the stock exchange. This is equivalent to placing a bet that you would win if the stock went up (India wins the match) and your friend would lose if it falls (India loses). Your friend is short on India, while you are long in market parlance.

Still confused? You might not be confused, but there may still be some unanswered questions. For those who are new to shorting, this is the most important point: Shorting stocks can help you make money if you believe the price of the stock will decline. You must sell stock and futures first, then buy later. The best way to learn how to short stock or futures is to actually short it and experience the P&L.

8.2 - Stocks that are shorted in the spot market

Before we can understand how to shorten a stock in futures markets, it is important to understand how spot market shorting works. Consider the following scenario:

  1. HCL Technologies Limited's daily chart is examined by a trader who identifies a bearish Marubuzo.
  2. Other checklist items, as discussed in the TA module, are also compliant with the bearish Marubuzo.
    1. Above average volumes
    2. The presence of resistance levels
    3. Indicators confirm
    4. The risk-reward ratio is acceptable
  3. The trader believes that HCL Technologies will drop by at least 2.0% on the next day based upon the analysis.

The trader now wants to profit from the expected price fall, given the outlook. He decides to shorten the stock. This is how we can better understand the trade.

StockHCL Technologies
Types of tradeKeep it short (sell first, buy later).
Types of tradeKeep it short (sell first, buy later).
Trade DurationIntra day
Get a Short PriceRs.1990/ -
Target PriceRs.1950/ -
% Profits Expected2.0%
Stop LossRs. 2000/-

We all know that when one shorts stock or stock futures, one expects that the stock price will fall and one can make a profit from falling prices. The idea is to shorten the stock at Rs.1990, as shown in the table.

When you are required to sell on the trading platform, you simply need to highlight the stock or futures contract you wish to shorten and hit F2 on your trading portal. Once you hit submit, your order hits the exchange. If it is filled, you will have created a short position.

Now think about this: Under what circumstances would you lose money if you entered a trading position? You would certainly lose money if the stock price moves against what you expected. This is how it works:

  1. What is the expected direction change when you short a stock?
    1. It is expected that stock prices will decline so the directional outlook is downwards
  2. When would you make a loss?
    1. If the stock moves in an unexpected direction
  3. What would that look like?
    1. If the stock price starts moving up instead of falling, you'll start to lose money

The stoploss price for shorting is always higher than the entry price. As you can see, the short trade entry price is Rs.1990/– and the stoploss price is Rs.2000/– which is Rs.10 more than the entry price.

Let's now imagine two scenarios after we have initiated the short trade at Rs.1990/.

Scenario 1: The stock price reaches the target of Rs.1950/

The stock moved in this instance as expected. The stock fell from Rs.1990/– to Rs.1950/–. The trader will close the position as soon as the target is met. We know that the trader must close the position within a very short time.

  1. First sale @ Rs.1990/ and
  2. Later purchase @ Rs.1950/ -

The trader would have earned a profit equal the difference between the selling price and the buying price, i.e. The price of Rs.40/- (1990-1950).

It is possible to look at the problem from a different angle, i.e. This is the same as buying at Rs.1950, and selling at Rs.1990. The trader simply reversed the order of the transaction by buying later and selling first.

Scenario 2: The stock price rises to Rs.2000/

The stock price has risen above the Rs.1990/- short price. Remember that if you are shorting, the stock must fall in price to make a profit. A loss would occur if the stock price rises. This would mean that the stock price has risen and there would be a loss.

  1. The trader sold @ Rs.1990/+. The stock rose after the trader shorted it.
  2. When the stock reaches Rs.2000/-, it triggers the stoploss. The trader must close the position by purchasing the stock back to prevent further losses.

The trader would have lost Rs.10/- during the entire process (2000-1990). This transaction can be viewed from the buy first, sell later perspective. If we reverse the order, it would be sell early and buy later.

These two scenarios should convince you that shorting is profitable when the price falls and losing when it rises.

8.3 - Spot shorting (The stock exchange's view)

The only restriction to shorting in spot market is that it must be done intraday. You can open a short trade at any time during the day. However, you must buy back shares (square off), by the end of the day. The short position cannot be carried forward for more than one day. Understanding how the exchange views the short position in the spot market will help you understand why it is strictly intraday trading.

You must sell your stock first if you are shorting in the spot market. When you sell a stock the exchange would be notified by the backend that you have done so. The exchange doesn't distinguish between regular selling of stock (from a DEMAT account) or a short sale. They believe that you have sold shares, which would make them obligated to deliver the shares. You must keep the shares in your DEMAT account ready for delivery by the next day. The exchange will only be notified of your obligation after the market closes, and not during market hours.

Keep this discussion in your mind. Let's say you shorted stock in hopes of getting a price drop. You decide to wait until the next day because the price did not fall as you expected. Exchange would determine that you sold shares in the course of the day and you would need to have these shares available for delivery. These shares are not required to fulfill your delivery obligation. This would mean that you will default on your obligation and there would be a severe penalty. This is also known as "Short Delivery".

The exchange would handle the matter and settle the dispute in the auction market if there was a short delivery. This articleon Z-Connect explains beautifully the auction market procedures. It also explains how a client can default on a delivery obligation. This is a reminder to not get into a'short delivery" situation. Otherwise, the penalty could rise up to 20%.

This leads to another important thought: the exchange checks for obligations even after the market closes. If one were to square off the short position, then the obligation would not be fulfilled by the exchange before it can conduct the "obligation check". Spot market shorting must be treated strictly as intraday trading and not carry forward any delivery obligations.

Does that mean that all short positions must be closed in a day? It doesn't. You can carry forward a short position in the futures market overnight.

8.4 - Shorting on the Futures Market

The futures segment does not have the same restrictions as the spot market. You can shorten a stock without restriction. Futures trading is a popular option. The 'futures,' a derivative instrument, mimics the movements of its underlying. The futures would fall if the underlying price is falling. If you feel bearish about a stock, you can take a short position on its futures. You can also hold the position for a night.

The short position would also require a margin deposit, just as you would deposit a margin to initiate a long position. Both the short and long positions have similar margins and they don't change.

Let's take a look at the following example to help you understand how Mark to Market (M2M), can be used to short futures. Imagine you have sold HCL Technologies Limited to Rs.1990/+. The lot size is 125. Below is a table showing the stock price movements over the next few business days, and the M2M-related data.

DayRef price M2MClosing priceP&L for the day
1 - (Initiate short).199019821000 = 125 x 8.
219821975125 x 7 +875
319751980125 x 5 = 625
419801989125 x 9 = 1125
519891970125 x 19 = 2375
6 - (Square Off)19701965125 x 5 = 625

These lines are marked in red to indicate that they are losing days. We could simply add all M2M values to get the total profitability of the trade.

+ 1000 + 875- 625 – 1125 - 2375 + 625

= Rs.3125/ -

Or, you could consider it as:

* Lot Size (Selling price - Buying Price)

= (1990-1965) * 125


=Rs.3125/ -

Shorting futures is similar to starting a long position in futures, but you only profit if the price falls. The margin requirement and M2M calculation remain the same.

Active trading is not complete without shorting. You should feel as comfortable initiating a short-term trade as you would with a longer trade.

To Summarize

  1. Selling first, buying later is what shorting means
  2. A short trade is only profitable if the closing price is lower that the entry price
  3. If the price rises above the price at which one shorted, it would be considered a loss.
  4. In a short trade, the stoploss is always greater than the price at which one has traded
  5. Spot market trading is only available on an intraday basis.
  6. In the spot market, short positions can not be traded overnight
  7. You can carry the short position in futures markets overnight.
  8. Both short and long trades have the same margin requirements
  9. Both short and long trades can use the same M2M calculation