Short selling is a trading or investing strategy that entails benefiting from falling prices of underlying assets or securities. Conventional trading involves speculating on the price of assets or securities rising. Likewise, in some jurisdictions and markets, it is also possible to speculate and benefit from prices of underlying securities dropping as well.
Investors buy shares of companies on the belief that their prices will rise to allow them to generate some profits on price differences. Likewise, with short selling, investors do the opposite and sell securities while anticipating price to drop significantly.
While short selling, investors or traders borrow shares of stocks or assets on the belief that their value will decrease over time. Upon the price declining to a preferred level, the investor would be able to offload the shares to buyers willing to buy after the drop.
Traders often use short selling to speculate on price movements on the downside. Portfolio managers, on the other hand, use the trading strategy to hedge against a downside risk of a long position. In this case, if a manager has a long position on an asset he may enter a short position to counter any decline that might come into play along the way.
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How to Short Sell a Stock
To short sell a stock, one must first open a margin account with a broker. Once a margin account is up and running, an investor must decide on whether to speculate on price movements via derivatives. With sufficient money in the account, one can consequently execute a sell order.
To close an open short position and take in profits on the price falling significantly, all you have to do is offload the shares and return them to a lender or broker. The process of shorting stocks and returning them back is handled behind the scenes with the broker, upon the execution of an order.
Short selling advantages
- Short selling provides an opportunity to benefit on the price of a stock or any other asset declining
- Short selling makes it possible to benefit when markets are going down and not when they are going up only
- With short selling, it is possible to monitor and control investment by using various tools such as stop-loss orders
- Short selling also provides an opportunity to hedge against a long position consequently benefit from a downturn as well
Disadvantages of short-selling
However, there are several potential problems that you can encounter when short-selling, which can make it much riskier than going long.
When you buy an asset, the maximum risk of your trade is that the asset’s price drops to zero and you lose your investment. When you sell an asset, its price could rise infinitely so there is no cap on your potential losses.
If lots of traders have a short position on a stock, its price may suddenly spike. This is most often caused by a positive development for the stock, which can lead a majority of traders to quickly try and close their short positions – this sharp rise in demand in turn causes its price to rise.
If you buy a stock, you might receive a dividend. If you short-sell a stock and it pays a dividend, you’ll need to pay the equivalent to whoever you borrowed it from. On short CFD and spread betting positions, meanwhile, dividends will be deducted from the funds in your account.
There are two main benefits to opening a position that makes you money when a market drops in price: speculation and hedging.
The ability to short-sell adds a whole new dimension of market movements to speculate on. Say, for example, that based on your technical analysis you believe that Apple stock is about to head down. An investor who only takes long positions has no way of acting on the opportunity. A trader with access to CFDs or spread betting can act immediately.
Hedging offers a way to insure against negative price movements in markets that you have a long position on. For instance, if you hold shares in several stocks featured on the FTSE 100, then a downward move in that index could negatively impact your portfolio. Go short on the FTSE 100, and you may be able to lessen the impact if your British shares start dropping in value.
Managing short-selling risk
The increased risks involved in short-selling make effective risk management hugely important. Here are a few tools you can use to limit your risk on broker platforms.
- Guaranteed stops will close your position once it rises to a certain point, putting an absolute limit on your downside – and you’ll only have to pay a small premium if your stop is triggered
- Trailing stops will follow your position if it earns a profit, then close it if it reverses by a certain amount
- Trading alerts will notify you when your market hits a certain level, but let you decide what to do next
What is the best time to look at shorting
There is no better time to consider shorting stocks than when uncertainty in the market is high and volatility increases. The US volatility index, commonly known as the ‘VIX’, is a great place to assess volatility, but it can also be seen in daily stock trading ranges and the five-day average true range (ATR).
When volatility rises, a deflationary mindset takes hold and market participants feel that there is high probability of buying at cheaper levels. Asset managers and pension funds who hold a mandate to only go long will generally pull their buy orders and liquidity tends to thin out. This is often labelled a ‘buyer’s strike’ and this is exactly where short sellers will come out to play, as prices tend to drop more aggressively as funds can have a greater influence on price.
Traders will also short sell a stock or an asset after a strong run in an effort to pick the top. This is generally a low probability set-up if it isn’t accompanied by strong signs of price reversal, and when it comes to short-term trading aligning the directional bias with the trend increases probability greatly. There are ways traders can trade reversals on markets very successfully, but it generally means waiting for price to confirm a move lower. In this situation, it is advantageous to initially start with a small position and add to it as and when a trend develops.
In an environment when an asset has had a really strong move, traders will often look at reversion to a mean. There are many methods of looking at this, but often traders will use technical indicators such as Bollinger bands and change the upper and lower bands to 2.5 standard deviations from the mean (the 20-day moving average), and perhaps combine this with the 9-day Relative Strength Index at very elevated levels of over 80. From here let price dictate and guide. If prices struggle to push higher the next day and the bears wrestle back control and technically we see confirmation of a reversal, then this can be a strong short sell signal for convergence to a mean.
Another higher probability strategy is to simply short a stock that is trending lower. Whether there are issues specific to the company, or the stock is just getting caught up in a macro sentiment, if an asset is trending then weakness often breeds weakness and this should frame the trading bias. If a stock is trending lower, the company has structural issues (perhaps they have a deteriorating balance sheet) and implied market volatility is elevated, then this is the perfect time to look at short strategies.
What is short interest?
Short interest is a metric that shows what percentage of a company’s total outstanding shares are currently held in short positions. It can be used to determine the overall sentiment that traders currently have on a stock.
Are put options short-selling?
Yes. Buying a put option gives you the right – but not the obligation – to sell a set amount of an asset at a set price before a set date in the future, and as such gives you a short position on the underlying asset. Other alternative methods of shorting include inverse ETFs, which are designed to move in the opposite direction to their underlying index.