Short selling has a fairly dark undertone to it. You normally associate short selling with very dark and secretive traders trying their best to break the stock or the market. In reality, short selling is nothing like that. It is just a view on the market. Just as you buy the stock when you expect it to go up you sell the stock when you expect it to go down. It is just a directional view on the stock and nothing else. Let us say, you are holding 2000 shares of Tata Motors and you expect the stock to correct sharply due to poor performance by JLR. What would you do? Obviously you would sell out of the stock and wait for a better price to get in at a later date. What if you did not hold the stock? The answer is you can still short sell the stock even without having delivery of the stock.
But the key question is when to short sell a stock. There are 2 options in front of you. You can either do short selling in spot market or you can do short selling in futures market. Here is a primer that covers all about short selling.
How to sell a stock when you do not own it?
There are two ways you can sell a stock without owning it. Firstly, you can actually short sell in the cash market. Here you have to be careful that you can only short sell intraday. That means if you sell a stock in the morning and you cannot give delivery then you need to necessarily cover your position (buy it back) before end of trade on the same day. Remember, Indian markets operate on T+2 rolling settlements. That means if you do not square up your positions on the same day then these stocks will automatically result in delivery. So if you have sold in the morning and not bought it back by evening then you need to give delivery of the stock. Remember this very important point when you are short selling in spot market.
Another option is to sell the stock in futures. In the case of Tata Motors if you do not have delivery of shares and still want to sell the stock, you can look to sell Tata Motors Futures. Here there is no pressure on you to cover the position by evening. You have the choice of 1-month, 2-months and 3-month futures to well. Of course liquidity will normally be limited to the first 2-months contracts only and hence you may have to roll over your positions. But your payoff will be exactly similar to selling the stock when the price goes down since spot prices and futures prices closely correspond to each other.
Why selling in futures is a better option than short selling in spot market?
While short selling appears to be a simple method, if you have a negative view on a stock it may be a better choice to sell in futures. Here are five reasons..
When you are selling in the spot market, your selling time span is limited to just one day. However, price movement may not happen on the same day and that means you will have to close the position at a loss. That way, selling in the futures is a better option.
Selling in the cash market runs the risk of short delivery. What do we understand by short delivery? Let us assume that you sold Tata Motors in the morning. Normally, intraday trading positions are closed out by the broker but the onus is still on you. In case you forget to close out your short position in the same day, it could result in short delivery. Under the exchange rules, short delivery goes to auction and the losses can be as high as 10-15% which will have to be borne by you.
The big advantage of selling in futures is that you can not only sell stocks but you can also sell indices like the Nifty and Bank Nifty. So you can take a view on a sector or the market as a whole life and play this trend through indices. In short selling in the spot market that facility is not available.
You can hedge your short position with options. When you sell in futures or in spot your call could go wrong. What do you do? When you sell in futures, you can hedge your position with options. So if you sell Tata Motors in futures you can hedge it by buying a higher call option. That is not possible with respect to short selling in spot market.
Selling in futures entails paying of a margin. In fact, margins are the same irrespective of whether you are long or short on futures. This allows you to take a short position in futures by paying only a partial margin of around 15-20%. This reduces your cost.
While the option of selling in the spot market is available to you, it has certain inherent disadvantages. In other countries, stock lending has taken off in a big way and hence short selling in spot is a more feasible option. Till that takes off in India too, selling in futures remains a better option!