Learn how to make money when the stock market is going down with our complete guide to short-selling stocks. Whether you’re new to trading or have some experience, this blog post will provide you with the information and tools you need to do well when the market is not doing so well.
The Context
Red is not always bad. Taking a short selling position entails betting against the market and making money when prices fall — PlanB
Long-term investing is firmly encouraged in our investing philosophy, but it shouldn’t always be boring.
Why should traders have all the fun, so long as investors can restrict their trading exposure to using only that fun money? In investing “fun money” is the money you set aside each month for anything that brings you joy and some pocket change. Here is a simple article that will help you learn how to short-sell stocks and earn some money even when the markets are declining.
Short trades aim to make money when the price of a stock declines.
Short trades entail borrowing shares to sell right away, then hoping to purchase them back at a cheaper price later on so that you can keep the difference. According to several well-known investors and industry professionals, short selling is crucial to the functioning of public markets because it enhances price discovery, promotes sane capital allocation, guards against financial bubbles, and exposes fraud.
What Is Short Selling?
Simply put, shorting a stock is selling shares that you do not yet own! This is done to profit from a stock’s predicted price decrease, which is frequently determined by reading technical charts and speculating ongoing economic trends.
From the perspective of conventional strategy, short selling is the opposite of a buy-sell transaction. In this sell-buy transaction, you simply “sell high and buy low” rather than “buy low and sell high.” For instance, you borrow and sell 1 share of a company for ₹100 and you wait for the market to get volatile.
As you had expected (basis charts & your skill), the price abruptly drops to ₹70. At that point, you decide to buy the same stock at the lower market price to return the borrowed stock, putting ₹30 in your deep pocket – Well, you just did a short trade. In contrast, conventional long trades aim to gain from increases in a security’s price. Long transactions frequently include purchasing shares and then reselling them for profit.
Shorting is not advised for those who do not grasp more complex trading concepts like risk-reward ratio or technical analysis because trading carries its own set of hazards.
Types Of Short Selling
Theoretically, short sales can be divided into two categories: covered short sales and uncovered (naked) short sales. Covered short selling refers to buying back borrowed securities to close out an open short position at a profit or loss.
It requires purchasing the same security that was initially sold short and handing back the shares initially borrowed for the short sale. Naked short selling, or naked shorting, is different from conventional shorting in that it is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed as is done in a conventional short sale.
This often turns out to be a disaster, especially when the seller does not obtain the shares within the required time frame, the result is known as a “fail to deliver (FTD)“. To allow a trade to take place when the order is filled, the transaction typically remains open until the shares are purchased by the seller or your broker. Naked short selling is prohibited in India, as it is in many other nations, and all investors are obligated to fulfill their promise to deliver the securities at the time of settlement.
Duration Of Short Selling
Borrowed stock transactions are settled across a variety of time frames.
From the perspective of day trading, a short sale must be resolved (squared off) at 3:20 pm IST, or the end of your trading day.
You can short any stock denomination in day trading, even one share.
If the trade is not squared off within the allotted period, the broker will compel an automatic square-off, which will result in greater fees and/or settlement at prevailing market rates. Shorting on a long-term basis, such as maintaining a short position for several weeks or months, is only possible in lots when trading futures and options (F&O). Here, you must short in lots or a predetermined number of units that necessitates high-value commitments as compared to the day trading alternative.
Short Selling Risks
There are dangers associated with shorting, and those risks are relatively greater than those of going long. For example, if you go long, the most you can lose is all of your capital.
Therefore, in the event of a price reversal, if you purchase a stock for ₹100, the most it may decrease by is ₹0. So, you will lose 100% of your invested money.
But when you short-sell, the loss might grow to enormous proportions. This means that if you short-sell a stock for ₹100 and it rises to ₹150, you will have to take a 150% loss by repurchasing and giving back the shares at the market price to close out your position. In a rare scenario, your losses as a short-seller can be way too high during a phenomenon dubbed a “short squeeze“.
This happens when a heavily shorted company unexpectedly appreciates, setting off a chain reaction of price increases as more and more short-sellers are compelled to purchase the stock to close out their holdings. Every wave of buying drives the price of the stock higher, harming those who are still holding short positions.
However, due to the trading price range mechanisms in place, this scenario is uncommon in day trading. It is though, highly possible in F&O because you tend to hold short positions for longer periods and you are also responsible for paying interest on leveraged capital used to purchase lots.
Capping Your Profits & Losses
While the profits take care of themselves, it is crucial to set limits on possible trading losses.
It’s commonly done through a “Stop-loss.”
The ultimate trading tool, “stop loss” is used to stop losses from escalating. It’s an investor’s instruction to a broker to sell a stock if its price drops to a certain point. Stop loss (if applied), can be easily invoked on most broker platforms when carrying out risky trading transactions. If you expect irregular price changes following the achievement of the desired price point, it can also be applied to cap-exit profits.
While trading, never, ever forget to place your stop loss.
The stop loss amount should be directly proportional to the sum of money you are mentally prepared to lose if your estimation proves to be incorrect.
Pros Of Short Selling
Every frolic has two flanks, and short selling is no different.
≡ You can profit in a bear market by shorting stocks.
≡ Short sales give you the chance to earn a sizable return without having to invest a lot of money upfront.
≡ If you currently own a stock, didn’t sell it before the downturn, and believe it would only decrease in value, shorting can help you protect your investment.
You can sell it short and profit at the very least from the remaining fall.
Cons Of Short Selling
≡ The stock price must decline for shorting to be profitable.
≡ Your loss might theoretically never end if the cost increases sharply, especially in unchartered territories.
≡ Shorting the stock of a firm by a large number of investors or fund managers can put the company into bankruptcy.
Conclusion
The financial market’s unique notion of short selling makes it possible for the majority of value investors to participate in some form of trading. Short-term trading is not for everyone since it takes years of practice to fully understand technical charts and learn risk-reward ratios. However, you may indulge yourself through day trading by shorting just a few stocks with your fun money if you simply want to test the waters and your limitations.
It is not appropriate for value investors to engage in shorting through the F&O market. This is mostly due to the criteria for lots, which can put huge amounts of your capital at risk. For starters, you must also have margin trading active on your account to engage in F&O shorting. This kind of functionality enables you to borrow money from your broker to experiment with significant risks.
Besides, you will also be required to pay interest on the borrowing since the full amount of the stock you are shorting counts as a margin loan from your account. In some cases, in F&O you’ll be required to pay a “cost of borrowing” for the shares, which might likely be higher in the context of the risk you take.
This concludes the knowledge you need to understand short-selling stocks.
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