Margin Trading - Short-selling

"Going short" is the opposite of buying long and investors do it when they expect the price of a stock to fall in the short run and profit from this drop. Lets say, you tell your broker you want to short-sell 100 shares of Tata Tea which are currently priced at Rs 40 each. This quarter's results of the company aren't encouraging enough and you are convinced the stock price will take a beating within a few days. The broker looks for someone who has 100 shares of Tata Tea and borrows them on your behalf for a short period and with the guarantee that you will return them in few days. You in turn sell these borrowed shares at Rs 40 each and hence get Rs 4,000. Now, if what you had hoped for does happen, and the price of the stock falls to say, Rs 20 after two days, you will do what is called "cover the short position". That means you buy back the 100 shares by spending Rs 2,000 and your broker in turn returns them to the person borrowed from. So, by short-selling you have earned Rs 2,000 (of course, slightly less after adjusting for the transaction costs and expenses for borrowing the stock). The advantage of selling short is that you get to sell borrowed stocks without putting in your money.

Short selling can be perilous. Suppose if the Tata Tea shares fall but only do so marginally, you might just be able to recover your money. Or if the shares take a much longer time to reach the Rs 20 level than you had hoped for, your interest on the money with which the broker had borrowed those shares will surmount. Additionally, there will be constant pressure from the lender to return the stocks. Worse still if instead of falling the stock price rises, you will immediately enter into a loss.

Both short-selling and buying long require a good reading of the market and correct timing.

Margin Trading - Buying Long

When you strongly feel that the price of a stock will go up and so much so that you don't mind taking some risk or added expense. You can make money by buying the stock now and selling it later when the price has increased. But what if you don't have the money to buy? Well, you could "go long" on that stock, i.e. you ask your broker to buy the stock without paying him the full amount now. Instead, you can pay him a token amount called the margin money. When you buy on margin you are actually buying stocks on credit.

Your broker will lend you the part money if you have enough collateral in the form of adequate stocks in deposit with the broker. Since it's a loan the broker is giving you he will also charge an interest. You could have also borrowed money from some other sources to buy those stocks. But usually brokers try to offer interest rates lower than other sources.

When the stock's price has indeed gone up, you sell the stock, pay the broker the price at which you had purchased it and pocket the difference (less the interest cost of the broker's loan and the transaction cost).

Buying long allows you to buy more shares than you can afford. And, if your hunch about a stock's price rise turns out to be correct, you stand to gain more than what you could have without a margin buy. But the longer it takes for the stock to rise to the price level you had expected less will be your gain. To be safe the stock price should rise enough to pay off the loan amount, the interest incurred and the transaction cost.

Buying long becomes risky if your calculations go wrong. If it takes a much longer time for the stock price to reach the level than what you had estimated, your profits will reduce because by that time the interest cost on the borrowed money would have also risen. And if your estimate completely goes wrong and the stock's price falls you immediately start making losses. To be safe the stock price should rise enough to pay off the loan amount, the interest incurred and the transaction cost.

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