How Does Shorting Work In Spot & Futures Market?3 min read
Did you know that you can sell a stock before buying it?
What is Shorting?
When you believe that a stock’s price is going to decline, you make money by selling the stock first and then buying it later when the price declines. This transaction is called a short.
Shorting in Spot Market
Let us first understand how shorting works in the spot market. Let us assume a trader exists who believes the stock TCS will decline by 1% the following day.
In the table below, the various details for the desired transaction are given.
In the table above, the stop loss is higher than the entry price because the trader would make a loss when the stock price goes higher. Here are two cases that can play out.
Case 1: The stock hits the target price of Rs. 3316.5:
In this case, the trader first sold the stock TCS at Rs. 3350. Then, the trader bought it when it reached Rs. 3316.5. In this transaction, the trader would have made a profit of Rs. 33.5.
Case 2: The stock goes up higher and hits Rs. 3383.5:
In this case, as the stock has gone up higher in price, the trader ends up making a loss. As the stop loss was set up at Rs. 3383.5, the stock was bought back at Rs. 3383.5 to prevent further losses. In this case, the trader ends up making a loss of Rs. 33.5.
From the two transactions, it is clear that in a short transaction, the trader makes a gain when price goes down and makes a loss when the price goes up.
Shorting in Futures Market
Let us now see how shorting works in the futures market
Shorting in the futures market has no restrictions like shorting in the spot market. This is one of the reasons why futures trading is more popular.
The short position in the futures market is similar to going long on a futures contract in terms of margin requirements. Let us take an example to understand how much money will one make in the case of shorting in the futures market.
Let us take stock TCS with the same short price and target price of Rs. 3350 and Rs. 3316.5 respectively. Let us also assume that the lot size is 300.
Profit = (Selling Price – Buying Price) * Lot Size
(Rs. 3350 – Rs.3316.5) * 300 = Rs. 10,050
So, shorting a futures contract is very similar to going long on a futures contract except that you profit when the price declines. Apart from that, the margin requirements and it’s related calculations remain the same.
Why Are Spot Market Shorts Limited To Intra-day?
One can only short a stock on the spot market on an intra-day basis. Why? To understand why this is so, we will have to understand how the exchange treats a short transaction. When one shorts a stock, the exchange does not differentiate between a short sale and regular selling of a stock. It treats both as the same.
However, in the case of a short sale, one would have to have the stocks ready for delivery. This is the reason why short selling should strictly be done on an intra-day basis. This means that if you short sell a stock, you should buy it back before the day ends. If you were not to do so, there would be a hefty penalty involved. This penalty could be 20% above your short price.
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