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Selling short in the derivatives market

Futures and options traders use the terms long and short similar to the regular equity markets. A long position means that the investor has bought the derivative instrument – futures or options. A short position means that the investor has sold the instrument. So selling short in futures is when the investor sells a contract, without owning one in attempt to profit on a favorable price movement downwards. The seller of a futures contract may own the underlying share to lock the sale price, especially when the market is favorable to the seller.

Can investors sell something that is not already owned by them? This is possible in derivatives market as this is basically an agreement to buy or sell something in the future. Since the investor’s obligation to sell the underlying asset does not occur until a date in the future, the investor can first agree to sell on paper. As long as the investor can buy back the contract before the future date, the investor can fulfill the obligation and realize the difference in favorable price movement. Because derivative instruments deal in the future, the investor can sell first without owning anything and buy back later.

One of the biggest advantages of the derivatives market is that it enables the investor to go short more easily than in spot market. In the spot market it may not be possible to effectively sell short without a substantial price drop especially if the volume sold is large. The regulatory authorities do impose several restrictions that seriously impair one’s ability to sell short in the spot market that are not applied to the derivative market. Selling short is one of the effective methods of hedging for an investor whose overall position is long. Derivatives market enables the investor to assume risk as per the investor’s risk appetite.

Another advantage of derivatives trading is that it is easy to capitalize on a price decline. The investor can sell short just as easily as going long. Derivative markets operate on margin trading and compared to the spot market this gives an advantage of leveraging. However if not handled with due care, leverage can also be one of the major disadvantages of the derivatives market.

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