Short positions are investment strategies in which an investor sells borrowed stocks in the open market with a view to earn profit. This type of position is built up by a trader usually when he/she expects the stock price to drop.
Short positions involve unlimited risk and a limited reward as a trader shorting a particular share worth Rs.30 can gain a maximum of Rs.30 per share if the share price falls to 0 but can end up losing a much higher value if the price goes on increasing. Thus, due to this, short position is a very high risk strategy as opposed to buying a stock and holding it for potential upside.
A short seller borrows the shares from his broker, who usually holds securities for another investor who has bought the shares of the same security. The lender will not lose on the right to sell the securities which are lent, as the broker is expected to hold a huge pool of such securities for various investors. The short seller usually squares up his position at the end of the day or at any time when the price of the security falls below the sell price of the trader and ends up making a profit on the difference.
To understand short positions, let’s take an example where a trader has sold 1,000 shares of Welspun Corporation at Rs.160. If the price at which the trader covers his position is Rs.152, the trader will make a profit of Rs. 8,000 [(160-152)*1,000] from the above transaction. However, if the price rises after the trader has sold shares at Rs.160 and increases to become Rs.170 and then the trader covers his position, the trader will have to book a loss of Rs.10,000 [(170-160)*1000].
Similar short positions can be taken using derivatives also, by -
- buying a put option
- selling a call option
- selling futures on the underlying asset