Short Selling The Shortcut To Make Money

Short Selling The Short-cut To Make Money! 

 One of the primary reasons individuals put their money into the stock market is because over time stocks tend to rise and provide a decent measure of returns for the investors. So the rule, ‘Buy Right: Sit Tight', is often quoted by numerous successful financial specialists. 'Buy right' implies purchasing quality stocks at a sensible price, while 'sit tight' means holding the stock for a reasonable period of time to realise the full growth potential of the stock. But the journey of wealth creation is not always a joyful ride, as the market is subject to downswings. There are some individual stocks which, notwithstanding the rise in the market, continue to languish due to various reasons such as terrible management, poor business prospects, increase in competition, new regulations which are not favourable for the company, and many other factors. These are the stocks most financial specialists attempt to stay away from. Be that as it may, how does one make profit when an individual has reason to believe that a stock or the market will be heading downward? One can make profit from the concept called 'short selling' or 'shorting', wherein they can gain from a decline in the price of the stock.

WHAT IS SHORT SELLING? Every investor understands the traditional approach to making profit in the stock markets. You purchase a stock today, then sit tight and wait for the price to go higher than the cost price you have paid, and when the price goes up, sell the stock for a profit. This is known as going "long" the stock. Quite simple and direct.

Short selling, on the other hand, is a similar procedure, but in reverse order. You sell a stock today, wait for the price to fall beneath the price you have paid, and then buy it at the lower cost. In straightforward terms, short selling or shorting means that you're offering to sell the stock in the market first and thereafter endeavouring to buy it later at a lower cost. It sounds a little peculiar and complex in the first place, but if you are completely new to shorting or to the short selling concept, just remember the following pointers:

1. When you are long on a stock, your goal is to first buy low and then sell high.

2. When you are short on a stock, your goal is to first sell high and then buy low.

FAMOUS TALES OF SHORT SELLERS: Chanos is best known for shorting stocks–making investments that pay off when share prices decline. In 2015, Chanos's short-only fund, called Ursus (Latin for "bear"), was up 10%, trouncing the S&P 500 by a wide margin!

His investment philosophy as given by Wikipedia as follows: He describes his investment strategy as being based on "intensive research into stocks" looking for fundamental and large market failures in valuation, typically based on underestimated or previously unreported failings in the business or market of a stock. He follows this research by committing to a (usually large) shortposition which he is willing to hold for long period of time–almost the mirror image of Warren Buffett's reputed "fundamentals+long stay" investment strategy. Because of this model, his investments function more like those of a whistleblower than most typical investments. Paul Tudor Jones made an estimated $100 million when he predicted Black Monday in 1987 and shorted the stock market:

Using technical analysis and historical S&P data, Paul Tudor Jones correctly predicted that the market was going to crash in 1987, and proceeded to massively short stocks. The Dow plunged 22% and estimates put his gains from that trade at around $100 million. (Source: bigtrends . com )

HOW DOES THIS MECHANISM WORK? You might be amazed to know how you can sell a stock even before you buy it. It's actually not as problematic as it seems, as the stock market has evolved and the mechanism of trading has just scaled up. To help you do a short sell trade, your broker will assist this process and may let you borrow a stock owned by another trader or, less frequently, owned by the broker himself. When you're ready to exit your short position, you cover the position by buying back the stock you had shorted. In other words, selling before you buy really means you're borrowing the stock before selling it short.

PROCEDURE FROM ACCOUNT OPENING TO ACTUAL SHORT SELLING OF SHARES: Open a demat and trading account: The shares which are sold or bought are always stored in the dematerialised ( demat ) accounts. The trading account act as the intermediary between the demat account and the bank account. The shares that are held in the demat account are taken and sold in the stock market using a trading account. If the trader only wishes to trade in Futures and Options, the same can be done by using a trading account. But, if the trader wants to trade in stocks, both demat and trading accounts are needed.

You need to get margin privilege from the broker: If your account does not have margin trading facility , request your broker to add it. Your broker will send some additional disclosures and ask you to sign a margin agreement. "Margin" means you have enabled your account to borrow cash or stock from your broker. Do take note that you will be charged interest and a maintenance fee on any money you borrow on margin in order to execute the order.

Start trading and place order: Once the account is opened, you can place a short sell order through online or offline mode through your ‘relationship manager'. To place a short sell order, you need to open short sell order and enter the price and quantity of stocks you want to short sell.

HYPOTHETICAL CASE OF SHORT SELLING Short selling can be done in the spot and derivatives market. However, short selling is restricted to intra-day in the spot market. So to know more about short selling in the spot market, let's take a hypothetical example:

Before the market begins, a trader named Anurag reads the news that base metals prices have plunged in the international market and, according to his interpretation, this would negatively impact the stock prices of base metals related stocks in the Indian markets.

So Anurag filtered stocks related to base metals sector and identified a weak stock in this sector named ‘XYZ' based on the technical study of the trendline as the stock had breached its trendline support on the daily time frame, along with a bearish candle.

So, in view of the above technical analysis, Anurag is convinced that the stock ‘XYZ' will decline by a good percentage in intra-day trade and he can take advantage from this decline.

Now, given this standpoint, Anurag wants to profit from the expected price decline. Hence, he decides to short sell the stock at the opening bell in the spot market and, as the day advanced, the stock price declined in line with Anurag's expectations and he covered his short position (bought back the stock) by end of the day before the market closed and made a decent profit in intra-day trade.

The above procedure is followed when a trader is willing to short sell in the cash market. It is important to remember the no. 4 line , which states that the trader covered his short position (bought back the stock) by end of the day before the market closes. Now it is important to understand one point that when you are doing short selling in the cash market or spot market, you need to cover your position by end of the day before the market closes, which implies short selling has to be done strictly on an intra-day basis.

In the event that you do not cover or buy back your position in the cash or sport market before the market closes, it will result in a short delivery.

So does that imply that all short positions have to be closed on an intra-day basis? Not at all, a short position created in futures market can be carried forward overnight.

SHORT SELLING A STOCK IN THE FUTURES MARKET: 

Shorting in futures has become most popular because it comes with no boundaries or restrictions as in the spot market. The short position can be held overnight. Here, like long positions, the short positions would require margins, which are the same as long positions and the mark-to-market (M2M) too remains the same.

Reasons why short selling makes sense: Stocks tend to decline much faster than they rise: This is because fear is a much stronger emotion than greed. At a point when individual people feel fear, they tend to exit their long positions quickly and massively. Markets can go into a free fall due to panic selling, and therefore, it is generally possible to make money faster by selling short than by going long. This is true at least when there is panic in the market.

Speculation: Speculation is the most common reason to short a stock. The motive is to take maximum advantage from the fluctuations in the market. If you are of the opinion that the market has overvalued a company, or you foresee negative events or company news that will affect the stock, a short position gives you an opportunity to make money– provided, of course, your view is correct. Fruitful speculation requires strong research and timely entry.

Can be used as a hedge: One of the crucial factors why traders go short is they use shorting or short selling as a mean to hedge their positions. In this situation, a "hedge" acts as an insurance. It is a trading strategy that shields you from some sort of potential misfortune.

For instance, suppose you hold stocks of company ‘ABC'. Maybe you rely on the dividends of this stock as a source of income. But you are worried that the approaching quarterly earnings might disappoint analysts and other shareholders and send the stock price spiralling down. To protect your investment from such potential decline, you can create a short position for the same number of stocks you already hold. This will "secure" your long position. If the share price falls, the profit in your short position will rise by an equivalent amount of loss in your long position. If the stock price rises, you will lose on the short position, but that will be counterbalanced by the shares you already own.

Short selling gives a significant edge in a bear market : A long only portfolio works well when the market is in a bull run. However, when you do both long and short positions, you open up yourself to profit from both the situations.

PRECAUTIONS TO TAKE WHILE SHORTING A STOCK: 

Stock should have liquidity and spread should be decent: There are two basic criteria when you short sell a stock, particularly on an intra-day basis. First, the stock should have decent liquidity, which refers to the availability of substantial number of buyers and sellers in the stock. If a stock is illiquid , it would be difficult to move out of your position. Spread is the difference between buyer (bid price) and seller (ask price) at the time of executing the order. If there is high spread in the stock at the time of squaring off the trade, one might not get the desired rate.

Skills: In a bull run, even a novice investor can make good money. Such investments, which count on a rise in stock prices, are fairly straightforward in the bull run. However, when it comes to short selling, the investor has to base his decisions on a lot of indicators, especially because his risk is unlimited (if shorted without stop-loss). The short seller should also have a good understanding of what can trigger the markets and individual stocks to rise or fall. This includes understanding how a panic situation can quickly unfold in the market. One also needs to be flexible and make quick decisions as the market situation changes.

Be alert when you short sell a stock on key occasions: There are a number of key events which can cause fluctuations in the prices of stocks and create volatility in the stock markets. Events such as the Union budget announcement, RBI's credit policy review, inflation data, earnings reports, among others. During such key macroeconomic events/announcements, there is huge fluctuation in stock prices and such high fluctuation results in huge upswings and downswings in the market, which creates panic in the mind of traders. Hence, it is advisable to avoid taking undue risk during such events. One of the recent events that comes to mind is the recapitalisation of public sector banks, Many traders who had taken a short position looking at the weakness in the banks' charts, scampered to cover their positions or suffered huge losses post the big announcement on the bank recapitalisation when PSU banks' stocks moved higher.

Stick to the plan and follow stop loss: Two key components of trading are knowing your risk and protection against loss. In case you are not aware about risk capital and loss protection, you should not be in trading by any means. No one likes to lose money. But since equity markets are volatile and will not always move in the direction we wish, you should understand that losses cannot be totally avoided due to volatility in the stock markets, but these can be limited if you follow a proper trading plan and stick to your stop loss strictly. Also, do not let your emotions get in the way of sticking to your plan.

Asymmetric Risk: One of the great things about investing in stocks is the concept known as asymmetric risk. Generally, this means while a stock can lose at the most 100 per cent of its value; it could potentially rise multiple times in its value, that is, it could be a " multibagger ". In fact, an outstanding business can grow manifold. Along these lines, one major victor stock can compensate for a lot of washouts in a diversified stock portfolio. With regards to shorting stocks, however, this asymmetric risk profile is flipped upside-down. That is because if you short a stock, the maximum gain you can hope to make is 100 per cent, which typically will happen only if the company goes bankrupt and its stock is deemed worthless.

SOME OF THE STRATEGIES TRADERS CAN FOLLOW FOR SHORTING IN THE MARKET: 

Bearish crossover on moving average: Two moving averages can be used together to generate crossover signals. Crossovers involve one relatively short time frame moving average and one relatively long time frame moving average. A bearish crossover occurs when the shorter moving average crosses below the longer moving average. This is popularly known as a 'dead cross'.

Bearish reversal candlestick patterns: Candlestick chart is a very common and widely used chart type in technical analysis as it helps identity the trend reversal easily and quickly. There are some candlestick patterns that are used for identifying the reversal of downtrend . Some of the important bearish reversal candlestick patterns are: hanging man, shooting star, bearish engulfing, dark cloud cover and evening star.

When a stock breakdown of trading range: A trading range is range where the stock has moved during a stipulated period of time. A short sell opportunity is created when the stock pierces this trading range on the lower side as it clearly indicates that the bears are in command and controlling the stock price movement. A breakdown will be usually followed by sharp declines, so it is advisable that you short sell and make some fortune.

Chart patterns: Patterns are one of the powerful approaches to anticipate the trend of the stock. Hence, while taking a short set-up , make sure you have a perfect set-up in place. Chart patterns increase the odds in your favour when selling short. Some widely follow bearish patterns are: descending triangle pattern, double top, rising wedge, head and shoulder patter , n etc.

Oscillator RSI: It has been observed that in the bearish range, the RSI tends to oscillate between 20-65 zones. Under this condition, whenever RSI reaches 60-65 zone, it is an overbought zone (it may be a good selling point). It has been observed that in the super bearish range, the RSI tends to oscillate between 20-40 zones. Under this condition, whenever the RSI reaches 40 level , it may be a good short sell opportunity.

THE DARK SIDE OF SHORT SELLING 

Everything has its pros and cons and short selling is no different. Shorting has its own demerits. Following are some of the demerits of short selling: Theoretically, short selling has infinite losses: When you buy a stock, the worst that can happen is that the stock goes to zero value and the maximum amount one can lose is the sum total invested in it. On the other hand, when you short sell a stock, you can lose much more. To elaborate, let us assume a trader short sells a stock named ‘ABC' at Rs.300 and the lot size is of 2,000 shares and margin money required for the trade is about Rs.50 , 000. After shorting , the stock goes to Rs.330 and your loss comes around Rs.30 * 2000=Rs.60 , 000, which could be more than the actual amount the trader had. Hence, the losses can be unlimited in short selling if the trader does not put a stop loss.

Short squeeze: Short squeeze is short seller's nightmare . In the event that are a great deal of buyers come in simultaneously to cover or buy back the stock for whatever reason, the stock price can spike abruptly. The short squeeze happens when there is a strong short build up in the stock and there is some very promising news for the stock and all the short sellers rush to cover their positions in haste. Some traders will be rushing for the exits, while others will be buying up the shares like crazy. As a short seller, you will invariably encounter this situation sooner or later.

No benefit of dividend/split or bonus: Being a short seller won't benefit you if a company announces a healthy dividend or bonus, as you are effectively betting against the stock without owning it.

Margin call: Another hazard is the margin call. If the stock price goes against your position, your broker will ask for additional margin money to hold the position. If you do not pay up, the broker can liquidate your position.

ALTERNATIVE TO SHORT SELLING: BUYING A PUT OPTION 

If you are bearish on a stock, you can take benefit of this view in multiple ways:

Square off the stock, if you own it. Short the stock, and if the price falls, buy back the stock.

Or you can buy a put option, which allows you to lease the downward price movement of a stock.

WHY BUY A PUT INSTEAD OF SELLING SHORT? 

The customary method of shorting is to sell a stock which you do not own and you expect the value of the stock to decline, so you can buy the stock back at a lower price. Your benefit is essentially the price at which stock was sold minus the price at which the stock was bought. But what happens in case the stock price goes up? Your losses start to mount and keep mounting till the stock price keeps rising. In fact, your loss is theoretically boundless, because there's no restriction to how high a stock price can move. So in basic terms, short selling can be tough as it exposes the trader to unlimited risk.

Hence, the best alternative available is to buy a put option for the stock. A put option gives you the right, but not the obligation, to sell the underlying stock at the strike price on or before expiration. Buying put option helps you to know exactly how much you could lose if your bet turns wrong. The maximum loss is the total premium you pay, which means that if you risk 5 per cent of your capital on short ideas, 5 per cent is the maximum amount you would lose in a worst case scenario. Another major advantage of put option is that if the investor has correctly forcasted the stock price decline, he will yield a better return on investment, i.e. by paying a small sum as premium, he can earn a good amount.

CONCLUSION: The Oscar winning movie The Big Short, which is about the guys who successfully bet against the housing bubble, gives us an idea on how short selling can be an exceptionally helpful apparatus for investors/traders who utilise it shrewdly. Shorting allows you to benefit from the fall in the value of a stock. Every investor should be familiar with short selling and know how to use it in appropriate circumstances.

However, just like every rose has its own thorns, short selling has its own shortcomings. It comes with theoretically unlimited risk attached to it, and hence you need to follow a proper entry and exit plan while engaging in short selling. Alternatively, in the event that you prefer not to get into the margin trading, you have the choice to buy put options when you are bearish on a specific stock, as in this case, your risk is limited to the amount of premium paid.

In a nutshell, shorting is one of the key arrows in the investor's quiver, if it is utilised astutely.

Sumeet Bagadia, Associate Director, Choice Broking

As a retail investor, how do I go about short selling? Short selling is a kind of trading in which we just need to sell securities without having them in the demat account. In a simple terms, short selling is the sale of a security that is not really owned by the trader. But the main question is: why go for short selling? Mostly, short selling is inspired by the speculation that the securities prices might fall from the present level, and hence one can earn a good return by purchasing it at a lower price. Though, if we talk about today's trading strategy, then most people like to trade in futures and options as these instruments are more convenient and easy to trade.

But still, the question is same, why to go for it? 1. Short sell privileges you to churn out a good return without owning a stock. You just need to pay a small amount called as "margin", rather than paying the full contract value,.

2. You can use short sell as a hedge trade, which may help your investment if you own that security.

3. In a bear market, you can use short selling, as one may not get an opportunity for long side trade. In short, a trader can make a good profit even in a bear market.

However, just as a coin has two sides, same way short selling has disadvantages as well. 1. A short sell trade makes money only if the stock falls as expected. If you are wrong and the price rises , then you may fall into a loss which may be unlimited if it is done without a stop loss.

2. A shorting in the cash market has one restriction–it has to be done strictly on an intraday basis.

Tejas Khoday, Co-Founder and CEO, FYERS

What factors should be kept in mind before selling short? Shorting is often a misunderstood activity and it is popularly conceived as something that only professionals should engage in. As a matter of fact, it is very simple and can be done by retail traders via derivatives (Futures & Options) and intra-day equity positions. The first thing to keep mind while short selling is the stop-loss. If you leave the trade open-ended, you could end up with a bigger loss than you initially anticipated. Calculating risk-reward before entering a trade gives you a sanity check.

Each market cycle has its own opportunities but , generally speaking, it is not advisable to try shorting at the highs expecting a reversal. It is similar to bottom-fishing and should be avoided at all costs. Such an approach is dangerous because bullish stocks can tear away to any heights without any rationality.

Hence, it is much safer to short when the stock/instrument has already started a correction because then you will be on the side of the trend, instead of fighting the trend. As the trade goes in your favour , you can always place trailing stop losses to protect your mark-to-market profits in case there is a sudden reversal. Aside from placing stop losses, you can also use options strategies if you are bearish on a particular stock. Some examples are: selling naked calls, buying naked puts, synthetic short stock, bear call spread, bear put spread, protective call , etc. These strategies are very different from one another, but it makes sense to study them and choose accordingly, based on the opportunity at hand.

What are the risks involved in selling short? If you're holding a naked short position, then the biggest risk involved is a reversal. When a stock bottoms out and begins to rally, it can be really fast and sharp, thereby potentially eating away your accumulated mark-to-market profits. The most direct way of protecting your profits is by placing trailing stop losses. In the alternative, you could also buy an out of the money call option as a near-term hedge to protect your profits if you want to continue to hold your position. You could also go long on another instrument or asset class which has a reverse correlation to your short position, just in case.

Of course, both these positions don't have to be entered simultaneously, otherwise it would defeat the purpose, but at times where you feel threatened of a possible pullback in the stock price, it makes a lot of sense. Overnight risk due to surprise announcements, earnings results, industry news or any related item can affect your position, but that goes without saying as it is no different from a long position. But usually, the reaction to the good news in a bullish market can be grossly exaggerated as shown by the recent stock market reaction to the news of recapitalisation of PSU banks. Large-cap PSU banks rallied by more than 35% in a single day. Anyone who had a short position without a hedge was in deep waters.

A trader needs to be aware of such risks and book profits whenever they can. Also, the duration of the trade should depend on the market cycle. For instance, if there are shorting opportunities in rising markets, then it is wise to exit trades sooner rather than later because of the age-old truth: A rising tide lifts all boats regardless of anything else.