Basically, shorting is the act of selling your stock to buy it later after the prices fall, when you anticipate that the prices are likely to decline. Let us understand the concept with a simple example. You bought a bungalow 2 years for a price Rs. 3 million and you sell it today for Rs. 4.5 million. The profit made on the transaction is the difference between the new price of bungalow and the old price of the same, which happens to be Rs. 1.5 million. This is a simple transaction and one can easily get it. But in the stock market, forex, currency or derivative market, price or value of an underlying isn’t likely to increase only. The value of a stock or derivative may increase or decline anytime and this is base of profit made or loss beard by a trader.
In this chapter we will discuss about shorting or a short sale with example with reference to stock market, forex market, derivative market, currency market or commodity market. Let’s take a scenario to better understand the shorting concept.
Suppose when a trader sees the chances of a downfall in the price of a stock, he decides to sell to another trader and buy it again when the price fall, in order to bag a profit. This act of trading is called shorting. If you are still confused, I am giving a real example to get it better. Suppose you have a stock of UltraTech Cement at and you have an expectation that the price of the stock may fall in upcoming hours or days. What you will do is that you will plan to sell the stock right and buy it back when the price falls.
Basics of Shorting or Short Sale:
Let us take the two scenarios to better understand the shorting methodology:
Scenario 1: Suppose you sold your stock for Rs. 790 and the price of the stock falls as per your expectation. You buy the stock back when the price falls to Rs. 750. Hence, you bag a profit of Rs. 40.
Scenario 2: Suppose you sold your stock for Rs. 790 and the price of the stock increase, opposite to your expectation. You have to buy the stock back for the price Rs. 810. Hence, you bear a loss of Rs. 20.
Rules of Shorting or a Short Sale:
A shorting or short sale on the stock market is a transaction in which you sell the actions taken by your broker. You agree to buy the shares later and return them to the broker. You make a profit if the share price falls and eventually buy the shares at a lower price than they previously sold. Short sales are governed by values and Exchange Commission regulations, stock exchange rules and policies of the individual agents.
You must have a margin account with your broker to initiate a short sale on the stock market. Margin accounts differ from cash accounts because they can borrow money or securities. A margin account is necessary because you are forced to borrow the shares when you sell a stock short. In addition, all funds in your account are collateral for the loan.
Your agent must own or borrow the actions required to borrow before a short sale can be initiated. No assurance actions before starting a short sale is called naked short selling. In 2009, the SEC (Securities and Exchange Commission) implemented anti-fraud rules prohibiting shorting or short selling.
Under the Regulations Board, you must be at least 150 per paisa of the value of the shares in your account to initiate a short sale. In addition, you must meet the minimum requirements for maintenance. Brokers tend to impose more stringent requirements of 130 per paisa to 140 per paisa. If the stock price increases to the point of your account balance does not meet the minimum, you must deposit more money. Failing so would lead to square off the position automatically from the broker’s or regulatory board due to the short fall of the cash margin required.
Because in reality no one’s action actions, you cannot receive the dividends paid on the shares, while the short sale is open. Dividends go to the owner of the shares. By the same token, you cannot claim the benefits and capital gains for tax purposes. In 2007, the SEC revoked the uptick rule, which prohibited the initiation of a short sale if a stock was falling in price. However, from 2009, the SEC is considering implementing a new uptick rule. The ban on short sales during a trading session once a stock falls 10 per paisa was under consideration.
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» e-Learning Chapter 3: What is Leverage and Payoff? Definition with Example.
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» e-Learning Chapter 8: What is Open Interest? Examples and Analysis.
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» e-Learning Chapter 10: What is Margin Trading? Advantages and Risk of Leverage.
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