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Short Sellers Add Liquidity To Markets

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There is a misconception among traders that short sellers, or short selling is bad for markets. In fact I talk to at least 10 traders everyday and 50% of them say they do not want to short sell by giving two reasons:

First reason – The margin blocked is very high by brokers and,
Second reason – It can make unlimited loss.

Well it is a misconception that short selling of options or futures is bad or unethical.

This is knowledge for those who only buy and never sell:

Who sells you the Equity, Options or Futures? They are the sellers. If no one is a seller a trade can never get completed. There has to be a buyer and a seller for the trade to be completed.

Do not forget that buyers have to become sellers one day when they decide to close their trade.

For example a trader bought an option for 80 and sold at 100 to book profits. When he bought the option he was the buyer, when he sold the option he become the seller.

Every seller has to become a buyer and every buyer has to become a seller to close their trades. When the trade is being closed they both have to change their positions.

Warning for Option sellers: On paper Option selling involves unlimited loss but limited profits. Therefore to safeguard and limit your losses, in case it happens, it is highly recommended that you hedge your sold options. But there is very conservative way to hedge the sold options and futures, which is well explained in my course.

There is also a general misconception among traders that short sellers try to bring the price down of an equity. Some even think, to bring stock price down of their competitors, some rich traders short their shares. This is not true. Whenever markets goes down it is blamed on short sellers, but the fact is if buyers are less than sellers, market or the stock goes down.

Shorting is just the opposite of buying. Those who think the stock may fall short it and those who think the stock may rise buy it. Yes sometimes the above does happen but it cannot cause a major outcome in stock markets. It can be ignored if you do not trade penny stocks. This the reason I highly recommended against trading penny stocks. Please do not get greedy and buy or sell unknown stocks even if your broker suggest you to do. Never trade penny stocks you can lose a lot of money.

Even in other businesses in the world short selling is done. For example a cloth wholesaler may sell the clothes to a merchant two months before the contract, take the money and deliver the products two months later. This is short selling.

Markets do need the short selling traders. Here are reasons why short selling is important for the stock markets:

  • If there are no short sellers, there cannot be any trade. Short sellers add liquidity in the markets. Without liquidity markets are non-existent.
  • Some stocks are unnecessary overpriced without any reason. These stocks may bring greedy investors to invest. It is short sellers who help in bringing the cost of these stocks down. Indirectly they help to save losses of greedy penny stock traders.
  • Remember the Satyam’s story? Their financial books were fraud. Once it was exposed the short sellers jumped in and bought the stock down from 200 levels to 10. The company is non-existent now.
  • Since short selling involves more risk, short sellers have to research very well the company before short selling it. In other words short sellers are very intelligent traders since they are taking more risk than buyers.
  • Brokers usually recommend buying a stock but rarely give a short sell signal because they know very well, as soon as a buy signal is generated, their clients would buy the stock, but if they give a sell signal their clients may ignore.
  • In a bullish market it is the short sellers who bring stability to the markets, especially when the markets become overpriced or overbought.

    Conclusion:

    There is nothing wrong in short selling, but please hedge your positions before short selling. Options are a great tool to hedge your trades. Whether you trade stocks, options or futures, everything can and should be hedged with options.

    Options were invented as a hedging tool and they should be used for that, even if you decide to trade options you can hedge them with options.


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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.

{ 1 comment… add one }
  • ashok

    I have enjoyed to read this article that is meaningful.
    Thanks,
    ashok

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