Refers to when investors sell their stake in a company only to buy it in the future when the share prices fall.
When investors sell their stake in a company only to buy it in the future when the share prices fall, they are said to have taken up a "short position." They do this in expectation of a price decline. Market sentiment plays a key role in their decision.
Let us understand the term "market sentiment." Market sentiment refers to investors' general opinion of the market's present and future performance.
Investors form these sentiments based on several qualitative and quantitative factors.
If a large segment of investors expect the market to show an uptrend, there is a bullish sentiment. On the other hand, if investors expect the market to display a downtrend, they express a bearish sentiment.
Based on these sentiments, investors take up a particular "position" on a given asset.
When the investor expects prices to increase, he would want to benefit from the price rise. For this purpose, he will purchase stocks, for example, when prices have not yet begun to rise, and sell them when the market booms. This is a "long" position.
Investors with bearish sentiments adopt a different strategy. Such an investor expects prices to fall and will sell stocks today when the prices are low.
As the market falls, he will repurchase the shares from the market, return the borrowed shares, and make a profit on the difference.
This is known as taking a "short" position. In this article, we will discuss strategies traders adopt to take up a short position and explore these strategies in the derivatives markets, specifically the futures market.
Taking up a long position is easy. An investor can purchase stock he does not yet possess. On the other hand, a complication is associated with taking up a short position.
Traders who perceive a downtrend would want to take up a short position. To do so, they must sell securities in their possession and repurchase them when the price falls. However, such a strategy is not always feasible.
What if the investor does not have the securities they want to sell in their portfolio? How can one sell something they do not have?
The investor will resort to "short selling." Stock lending and borrowing permit this type of position. Let us examine an example to understand how short selling works.
Investor X expects the market to fall sometime soon. To leverage this, he wishes to sell 500 shares of MonkeyArmy Ltd. The shares are currently valued at $80, and he expects the price to drop to $55 in the next year.
He opens an account with a broker to facilitate the sale and borrows 500 shares at $80 per share from the open market. This brings the sale value to $40,000. What does the lender gain from this transaction?
To borrow the stock, investor X must pay a periodic fee to the lender. For example, let's say the interest rate charged on this transaction is 5% per annum.
Once he borrows these shares, X will sell them in the market for $40,000. After a year, just as he predicted, the share price dropped to $55.
X will now repurchase 500 shares at $55 per share. This brings the purchase value to $27,500. As a result, X's net profit is as follows.
|Sale of 500 shares at $80 per share||$40,000|
|Less: Repurchase price of 500 shares at $55 per share||$27,500|
|Less: 5% interest paid on borrowed shares||$2,000|
|X's net profit||$10,500|
What if X's prediction is entirely off the mark, and the market displays a bullish trend? Let's say the share price rises to $100 after a year. In such a situation, X must close his position by paying more than the sale value, incurring a loss.
Closing a position refers to exiting the position the investor has taken up. He must sell the shares if he has taken up a long position and buy the shares if he has taken up a short position.
Risks of short selling
Of course, no venture comes without its risks. But, at the outset, short selling looks like a lucrative option to cash in on falling prices.
Consider this: an investor who wants to short a stock priced at $50 borrows 100 shares. He sells them and repurchases them for $45 a year later. His gross profit is $5 per share. His total gross profit is $500, as he borrowed 100 shares.
However, notice the impact on his net profit. Assume he pays interest of $1000. Though the market was bearish, the investor suffered a net loss of $500.
Ultimately, this means that, for a short position to be most profitable, the market has to see a downturn soon after the position is entered.
What is naked shorting?
Warning! What you are about to read is flagrantly illegal. Ignorant traders have executed the following transaction under no supervision. Please do not attempt this anywhere.
Naked shorting, or naked short selling, is the practice of selling shares that an investor neither has possession of nor has borrowed from another investor. Essentially, the shares don't exist.
Does naked shorting happen today? Yes. There are always loopholes in the system. Is it illegal? Absolutely. The 2008 financial crisis was the catalyst for this practice being declared illegal.
How exactly does naked short-selling work? Once you enter into a transaction, you must settle the transaction on the due date. Depending on the country, the settlement date may be T+1 (trade date plus one day) or T+2.
Settlement refers to closing the transaction. If you are a buyer, you must pay money for the shares. On the other hand, if you are a seller, you should deliver the shares. The delivery or payment must happen on or before the due date.
As you already know, traders who engage in naked shorting do not possess the stock. Once they enter a sale transaction, they must acquire the stock before the settlement date.
If this does not happen, it is known as a "failure to deliver." More often than not, naked shorting results in a failure to deliver.
What are futures contracts?
The nuances of the derivatives market are beyond the scope of this article. However, an introduction to futures is necessary to understand the shorting strategies employed in this market.
Taking a real-world example will help better understand futures. This example will deal with forwards, but both markets are essentially the same, with a few key differences. For example, assume that the price of a particular crop in the market is $20.
A farmer awaiting harvest season expects the price of his crop to fall to $10 in the next two months due to low demand. However, a manufacturer who uses this crop as raw material expects prices to increase to $25 during the same period.
Both parties have different price sentiments and want to protect their interests. Therefore, they would enter into a "forward contract."
The farmer agrees to sell his produce to the manufacturer at a mutually agreed upon price, on a specified date, and per the terms of the forward contract. The manufacturer, in turn, agrees to purchase the crop on the same terms.
This provides a safety net to both the farmer and manufacturer. In addition, the contract is unaffected by price fluctuations.
The seller's risk is technically unlimited (if the underlying asset's price rises to infinity). In contrast, the purchaser's risk is limited to the contract price (if the underlying asset's price falls to zero).
Let us say the mutually agreed-upon price is $15. If the crop's market price after two months is $18, the farmer loses $3 because he could have sold the produce in the market for a higher price.
Similarly, the manufacturer gains $3, as he could buy the produce from the farmer at $15, whereas he would have had to pay $18 in the market.
Irrespective of market price, the parties would have to trade at $15. The risk with a forward contract is that, since the farmer incurs a loss, he may very well back out of the contract and sell his produce in the market for a higher price.
The problem with a forward contract is that there is absolutely no accountability. The manufacturer has no legal recourse if the farmer defaults.
Mechanism of a futures contract
Enter futures contracts. A futures contract, at its core, is similar to a forward contract. The difference between these two contracts lies in their legal enforceability.
A futures contract places an intermediary between the two parties. This intermediary ensures that neither party backs out of its obligation. In financial parlance, such an entity is called a "clearing house."
Firstly, the clearing house requests both parties to deposit a caution margin. Let us say the margin for the transaction above is $40. Both the farmer and the manufacturer deposit $40 with the clearing house.
Since the manufacturer's net gain and the farmer's net loss is $3, this amount will be deducted from the farmer's account and deposited into the manufacturer's account on the settlement date.
Therefore, the net balance in the farmer's and manufacturer's accounts stands at $37 and $43, respectively. Therefore, this amount is refunded to them by the clearing house.
Simply put, forward contracts are not derivatives, at least not legally.
They are what are known as "over-the-counter" transactions. These transactions happen without the intervention or supervision of a regulatory authority.
As such, forward contracts carry no legal meaning, and the aggrieved party cannot enforce them in a court of law. By intervening, clearing houses create a standardized contract that the parties cannot violate.
Now that we have explored the futures market, let us look at how the shorting strategies work.
Arbitrage strategy in the futures market
Arbitrage refers to leveraging price differences in two or more markets. Such price differences are rare and minuscule. In the context of the derivatives market, arbitrage refers to trading in the spot and futures markets.
A spot market is the traditional financial market where securities are bought and sold daily, and settlements are immediate.
We know that too short a stock, a trader must borrow the security he does not have and sell it in the spot market. An alternative is to borrow money from a broker and invest it in the same security.
Let us look at an example to help us understand the shorting strategy in the futures market.
Company ABC's shares currently trade at $250 in the market. In addition, the market interest rates stand at 7%. Therefore, we can use the compounding formula to calculate the stock's price after one year.
P0 [(1 + i)^n] = P1
Where P0 = price of the share today
i = The interest rate or compounding factor
n = Compounding period, which, in this case, is one year
P1 = price of the share after one year
The interest paid on the security is embedded into its price because it affects the net gain on the transaction. If we compound the share price using the interest rate of 7%, the share price in a year should be $267.50.
This price is known as the "fair value," i.e., without considering market fluctuations.
Futures that will be executed a year from now are currently trading at $300. So does an arbitrage opportunity exist? Yes.
This is because there is a difference between the stock's fair value and the stock's actual future value. Therefore, the investor can exploit this difference.
Since the actual future value of the stock exceeds its fair value, it is considered overpriced in the futures market. If the share is overpriced, its price will go down soon.
To gain in the future, the investor must short the stock in the futures market. Therefore, he must purchase the share today, i.e., in the spot market, and sell it in the futures market to gain from the expected fall in price.
- The investor will purchase the stock at $250 by borrowing this amount from their broker at an interest of 7% per annum.
- The contract has a future price of $300. So next, he must enter into the futures contract to sell the share he currently holds at $300.
- On the settlement date, he will sell the stock at $300.
- The investor had borrowed $250 from the market at 7% interest. The compounded value of this borrowing is $267.50. He will repay this amount.
- The investor's net profit stands at $300 - $267.50 = $32.50.
- There are two kinds of market sentiments. When investors expect prices to rise, there is a bullish sentiment. When prices are expected to fall, there is a bearish sentiment.
- Investors take a short position when they expect the price of a stock to fall, i.e., they express a bearish sentiment.
- Investors use various strategies to enter a short position. Short selling refers to borrowing stock an investor does not have and selling it at a higher price. The stock is then repurchased later at, hopefully, a lower price returned to the lender. The profit is the price difference.
- Another strategy used by investors is known as naked shorting. Naked shorting refers to shorting stock without holding it or borrowing it from the open market. This practice is illegal.
- Short selling has many risks. If the investor's prediction is incorrect and the market expresses a bullish sentiment, there is no limit to the losses they may incur. Furthermore, share borrowing payments erode the net profit on the transaction.
- The investor can short the stock in the futures market through arbitrage. If the share is overpriced in the futures market, its price will go down soon.
- To profit before the fall, the investor will buy the share in the spot market and sell it in the futures market at a higher price.