All about Shorting: Things to do with futures

In this chapter, we are introducing another essential aspect of trading which is called shorting. In our day-to-day life, we hardly come across transactions which involve shorting. Let's understand the shorting with an example- Rajesh buys gold for Rs. 20,000 and sells it at Rupees 35,000. Now the profit he makes on this transaction is off ₹15,000. ₹15,000 is the incremental value over and above rupees 20,000. This is a fundamental transaction which we come across regularly. Many times, we buy something and sell it for a profit or a loss. However, in short selling or shorting the transaction which happens is exactly opposite of the transaction which took place in this example; therefore, in shorting, we first sell and then buy later.

Let us say Rajesh is now about to do a shorting transaction. So, what are the circumstances where he would want to sell something first and then buy it later? The answer to this is when the price of an asset such as stock is likely to increase; he would buy it first and sell it later. However, when the price of a stock is going to decline, then he will sell it first and buy it later in favourable conditions.

If Rajesh believes that the price of the security which is at Rs 10,00 at the moment is going to decrease in the future, he may decide to short it right away. There are two types of short positions- naked and covered. Let us understand the short positions now.

Short positions

Before we explain what short positions are, you need to understand as a trader that there are a lot of potentials to earn a profit while creating a short position and also the risk of losing is equally the same. The reason for this is that the profit potential is limited to a distance of stock to 0. A stock may rise for years which can result in a series of higher highs. The potential of short-squeeze is the most dangerous aspect of being shot.

Shorting in the Futures Market

Just like shorting the stock in the spot market, there is no restriction whatsoever on shorting a stock in the futures segment. You need to understand that the futures derivative imitates the movement of its respective underlying. The futures will go down if the underlying value is going down. Therefore, if the chances are that you are bearish about a stock, then you may consider to initiate a short position on its futures and hold on to it overnight.

This is the same as when you have to deposit a margin when you initiate a long position; the short position also requires a margin deposit. And note that the margins are the same for both the long and short positions.

Let us understand the ‘Mark to Market’ (M2M) perspective when you would short futures with an example. Rajesh has shorted HCL Technologies Limited at Rs.1990/-. The lot size is 125. The table below shows the stock price movement over the next few days and the respective M2M –

The two lines marked in red highlights the loss-making days. To get the overall profitability of the trade, you need to add up all the M2M values – 

+ 500 + 437.5 – 312.5 – 562.5 + 1062.5 + 312.5

= Rs.1562.5/-

Alternatively, it can be seen as–

(Selling Price – Buying price) * Lot Size

= (995 – 982.5) * 125

= 12.5*125

=Rs.1562.5/-

Therefore, shorting futures is the same as when you initiate a long futures position, other than when you are shorting your profit in the case when the price declines. Other than this, the requirement of margin and the M2M calculation is the same.

We can now say that shorting is an essential component of active trading. You must get comfortable with initiating a short trade and long trade equally.

In this chapter, we have understood shorting in futures. Now we can move to the next important topic - Things to do with futures: hedging? 

A quick recap

• You can only short based on intraday in the spot market.
• You cannot carry forward short positions overnight in the spot market.
• You can carry forward the short position in the futures market overnight.
• Short and long trades have similar margins requirements, and so does the M2M computation.