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How To Manage Risk Short Selling Stocks


What is Short Selling?

Short selling is selling stocks without have the stocks in demat account. Short selling equities must be closed the same day (intraday) or market makers will close the stock in auction and you will have to accept whatever price market makers get in auction. Usually this results in losses. Therefore short selling should be done intraday only and must traded under (MIS) Margin Intraday Square-off.

Short selling can be done in derivatives (options and futures) if the trader wants to hold the position overnight. But overnight gap up and down comes with huge risk. Overnight losses can exceed 10,000.

Does it mean over night short selling using derivatives is very risky?

Yes it is. Most short sellers lose their short when the stock gaps up the next day. Sometimes the risk management team square the position themselves to manege risk. They are under no obligation to inform the client of an automated close-off if the risk goes beyond a limit.

Does it happens every-time when the position goes in risk?

When shorting a stock in derivative segment, the broker blocks minimum 60k depending on the stock volatility and lot size. What needs to be blocked is decided by a software for each stock. Most brokers block slightly above NSE stipulated rules for derivative trading to remain risk free.

So when the position loses 80% of its value the risk management team calls the client to explain them the situation and warn them that if they lose 10% more they will have no other option but to close the position.

But in some cases the loss is more than 90% of the margin blocked when the stock gaps up the next day, in such cases the broker is in huge risk and has no time to call the client. In such a case the broker or the system closes the position without informing the client.

Do brokers have the right to close the potion without informing the client?

These situations comes rarely when stocks gaps up more than 10%. But yes they have the right as brokers are taking risk on your behalf when you short sell a stock. They are liable to pay the loses to the exchange therefore money is blocked in your account. Its not the brokers who keep the money – when a loss happens the broker will have to settle the amount (MTM) everyday to the exchange on futures trading. Losses/Profits from all their clients account is calculated and settled to keep the accounts up and running.

If one broker defaults then the whole system will collapse. So the broker does not want to get into any kind of danger zone. To avoid this situation they cut the losses. You can say stop-loss being taken by the broker on your behalf.

How To Manage Risk Short Selling Stocks?

Short Sell Stocks With Less Than Expected Earnings

You can read in various websites the market expectation of a company during the result season. You can short sell stocks that declared profits less than market expectation. Chances of winning percentage will be high.

Risk Manage The Leverage When Shorting

Leverage if managed well is not bad, but some people over short sell. This is not good. You cannot get stubborn when short selling. Nothing is guaranteed – just because you think the stock may fall it may not fall. So go as per the expectation. Even if you have the money to leverage more – do not trade more lots than you cannot handle.

If the stock gaps up there is lot to lose, so trade with the lowest amount of leverage or lots.

Keep A Stop Loss When Shorting

This is very important when shorting a stock. You must know how much you are willing to risk. Do not take more risk than what you have decided. Once that limit is reached take a stop loss.

Small losses are ok, but big losses are not. Small loss can allow you to live to fight another day and potentially make a big trade.

Do Not Short Sell A Stock If It is Gapping Down and Hitting The Circuit

Some people short sell stocks that are hitting the lower circuit whenever the trade opens. This can be dangerous. Eager buyers are waiting for trading to resume in such stocks so that they can buy.

Once such a stock bounces back – it keeps hitting the upper circuit. You will not be able to get out of the situation even if you want to. There is a chance that you will lose entire margin blocked for this trade.

Trend of Overall Market is Important

In a bullish market its better not to short sell. The stock may reverse as soon as you sell it. Short sell when the markets are in a down trend.

Hedging Short Sell is Important

Overnight gap up can be dangerous as trader cannot take a stop loss overnight. The only way left is to take a stop loss. But if you hedge your trades losses will be minimized whatever happens and profits will soar.

Hedging is a great way to trade peacefully as hedging ensures that losses are restricted while the profits soar.

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About the author: I started trading stock markets since 2007. However my first 3 years were losses. Then I dedicated almost 1 year on studying, researching, paper trading options and learned a lot in that time. Since 2011 I am trading Nifty options profitably. Call me if you need any help trading options on 9051143004.

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