Short Selling

What is Short Selling?

The term “Short Selling” originated in the stock market. A few years back, a person loaned stocks from his broker in order to sell them, and attempted to make a profit. Today the term “Going Short”, or just “shorting”, was adopted in the trading world, and it means selling an instrument. Respectively, buying an instrument is called “Going Long”, or just “Long”.

When thinking of trading most people think of buying an asset and then selling it to make a profit, but that’s only one way to make a profit in the markets. Another way is through a short sale, which capitalizes on falling prices rather than rising prices. The concept is a fairly simple one, a trader borrows an asset from the broker, sells that asset, and later buys it back to return it to the broker. If the price fell in the meantime the trader gets to keep the difference as profit. Short sellers believe the price of an asset is going to fall, and they are able to profit from such a drop.

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The Risks of Going Short

One thing short sellers need to contend with is the heightened risk that comes with this type of trade. When a trader is buying assets to go long they can only lose as much as they have invested in the trade. If they buy oil at $45 a barrel the most they can lose is the $45 because the price can’t drop below $0. The farthest any asset will fall is to $0 and the most a long trader can lose is the total amount of the investment.

However in the case of short selling the potential loss is infinite because the price of an asset can theoretically continue rising forever. In the example above if the price of a barrel of oil rose to $200 before the trader could close their short position they would lose $155 for each barrel of oil they were trading on.

The Reasons for Going Short

There are two purposes for a short sale. One is as a speculation on the price of an asset and the other is to hedge another position. In the case of speculation, traders will use a short sale to try and profit from an expected decline in an assets price. Hedgers, on the other hand, use a short sale as a way to protect profits already made or to minimize potential losses for an asset they already own.

In the case of professional investors and institutions sometimes short selling is done both for hedging and speculation at the same time. Hedge funds are well-known as some of the most active short sellers and they will frequently open a short position to protect a long position they already hold.

Short Selling Example

Returning to this article’s favourite instrument – crude oil trading.

• Say its price when the markets open on Monday is $44.50.
• In regular trading, if a trader believes the price will rise, he will open a buying position, and if the price went up to $45.50, his profit is $1 for every unit sold.
• With short selling the trader can act as the seller; if the expectation is for the price to drop, he would open a selling position for this instrument.
• If the price got to $43.50, his profit is $1 and he can now close the position, meaning he “buys” the instrument for a better price.

When to Consider a Short Selling Strategy

Most investors don’t use the short selling strategy because most people are always hoping and expecting that the price of assets will rise in value, not fall. In general prices do tend to go up, but there are also periods when prices head consistently lower. Consider too that for those investors with a long-term time horizon, buying assets and waiting for them to appreciate in value is less risky than short selling.

Short selling does have its place though. In some cases it becomes almost obvious that the price of an asset is going to fall in the short term. This is exactly when short selling makes sense. If interest rates are rising it could be a good time to short gold. If the U.S. dollar is strengthening it could be a good time to short gold and oil. If a company is going through difficult times for any reason it could be a good time to short their stock.

Short Selling Example

Returning to this article’s favourite instrument – crude oil trading.

• Say its price when the markets open on Monday is $44.50.
• In regular trading, if a trader believes the price will rise, he will open a buying position, and if the price went up to $45.50, his profit is $1 for every unit sold.
• With short selling the trader can act as the seller; if the expectation is for the price to drop, he would open a selling position for this instrument.
• If the price got to $43.50, his profit is $1 and he can now close the position, meaning he “buys” the instrument for a better price.

Finding Short Sale Candidates

Because the natural bias for markets and individual stocks is to rise, selling short can be fraught with risk. This makes it so important to know how to identify when a stock is ready to fall and continue falling so you can take advantage of the move lower. I don’t know of any golden rules for short sellers, but if there were one of the top would be to look at stocks that are up 300% or more as strong candidates for a short sale.

With some growth stocks price may begin to falter after a small gain, and it will look as if the stock is getting ready to break lower. However this is often just a period of consolidation for the stock before it takes off higher again. These are the situations that give short sellers nightmares since they can lead to sometimes large losses for the short selling crowd. Professional traders know all too well how common it can be for a stock they’ve just shorted to start creeping higher rather than breaking down as expected.

So, look for those stocks that have been big winners and then keep an eye on them to look for signs that the rally might be breaking down. There are a number of ways you can identify a growth stock that’s run too far and is beginning to break down. One classic sign is a topping pattern like a head and shoulders, a double top, or a triple top. Another is a failed breakout from a base that’s been formed in the late stages of a rally. In either case you should also look for price action to become increasingly erratic as institutional investors start to dump the stock.

Some other technical signals of a former high-flying growth stock beginning to break down is the break below key moving averages such as the 50-day or 100-day lines on heavy volume. Either could be the signal to short the stock. Once the price reaches the 200-day moving average it could be too late, so be careful around that level. In an ideal set-up the stock would also have a weak relative strength and/or accumulation/distribution rating. Both send a signal that institutional selling is growing. Best of all is if the broader market is also beginning to enter a correction, as that can provide additional downside pressure for stocks that have become weak.

Short Selling in Spread Betting

The same concept of short selling on regular trading, applies to spread betting. If one believes a certain instrument’s value will rise he can place £10, for example, for each pip the price moves. If, however, the instrument’s value is expected to decrease, he can place the same £10 for each point it goes down, and make the same profit.

Short Selling with AvaTrade

Short selling is a well-accepted trading method, and can be applied to all types of instruments – forex, commodities, stocks, bonds and others. Since it enables you to trade and benefit also when the markets are down, it is important to find a broker that has a well-established trading analysis, which will help you decide whether you should go long (buying) or short (selling). This, with a combination of over 250 instruments, that AvaTrade offers to its clients, provides countless trading opportunities and high profit potential.

Short Selling main FAQs

• How can you manage the risk on a short sale?

  Because the potential loss on a short sale is unlimited it is critically important that traders work to proactively manage that risk. There are several ways to do this, including the use of a buy stop order to protect against the price of the underlying going up too much. An alternative is to place a trailing buy stop order that will follow the price of the underlying by the amount you specify and only trigger if the price goes against you. This allows you to let your winning short trades run.

   
• Why would I want to sell short?

  Most people look to buy assets when the price is rising, but shy away from profiting from a falling price by short selling. However, there is nothing inherently wrong with making a profit from a falling price when you are bearish and believe the price will continue falling. This is especially true for short selling with CFDs where you aren’t actually selling the underlying asset, but are instead speculating on the changing price only.

   
• What is naked short selling?

  A naked short sale is the illegal practice of short selling shares that do not exist. Typically, in short selling the trader must first borrow shares in order to sell them short. But with naked short selling there are no shares borrowed and so the short sale puts more short pressure on the stock that could be larger than the available tradeable shares. Naked short selling was made illegal in the wake of the 2008 financial crisis, but it still occurs at times due to loopholes in regulations and differences between electronic and paper trading systems.

   

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