Most investors make money by buying securities in anticipation that their prices will rise over time, and then selling them at a profit later. This is known as ‘going long’. Contrarily, short selling is a way to make money in a bearish market by betting that a security will decline in value. Beneath the surface of seemingly altruistic efforts, short sellers possess a profit motive, aimed at profiting from impending drops in securities prices. Ideally, you must have a cast iron stomach to be a good short seller!
What is Short Selling?
Short selling refers to the practice of borrowing securities from a broker and promptly selling them with the anticipation that their price will decrease shortly. Once the price falls, the trader repurchases the security at the lower price, returns it to the broker, and keeps the profit that results from the price difference, excluding any loan interest. The theoretical risk associated with short selling is infinite, which is why it is only recommended for experienced investors.
To illustrate, imagine you borrow ten shares of a company and sell them immediately on the stock market for $10 per share, earning $100 in total. If the share price falls to $5, you could use the $100 to repurchase all ten shares at the lower price of $50, return them to the broker, and earn a profit of $50 on the short position, after accounting for commissions, fees, and interest.
Short selling was once viewed negatively because profiting from a company’s misfortune and a declining stock price was seen as cynical, leading to critics labeling those who engaged in it as “bottom feeders.” However, despite this perception, short sellers have always played a vital role in markets by exposing weak companies, fraudulent behavior, and falsified financial data. Their actions promote market efficiency and honesty to some extent.
Why ‘Short Selling’ a Financial Asset?
To Speculate: Traders employ the short selling strategy as a means of speculation, which involves assuming a high level of risk in exchange for the possibility of high returns. While long-term holders tend to analyze a company’s financials, management, and growth potential to make decisions, speculators typically focus on analyzing short-term price movements and market signals to seek quick profits.
To Hedge: Shorting a security can also function as an hedging approach. For example, if an investor has doubts about a company’s near-term performance but wishes to maintain a long position in its shares, they can sell them short to offset potential losses. This approach involves retaining their shares for the long term while buying back in at a lower price if the stock’s value drops. The objective is to mitigate the losses of their long position.
What Is a Short Squeeze?
When an asset’s price experiences a sudden surge, investors who had taken short positions on the asset will hurry to purchase shares in order to cover their positions. This leads to an increase in demand for the asset, attracting new investors to buy in as well, which pushes the asset price up even further. This phenomenon is referred to as a short squeeze, and it can cause short sellers to suffer losses that are significantly greater than their initial investment.
The short squeeze experienced by GameStop's shares in 2021 serves as an example, as short sellers expected the stock price to fall but it did not, resulting in estimated shorting losses of up to $5 billion according to analysts.
How Short Selling Differs from Traditional Trading?
Short selling differs from traditional trading in several ways:
- Direction: When trading, assets are usually bought with an expectation that their prices will rise, while when short selling, assets are sold with the expectation that their prices will fall.
- Timing: As a traditional trader, you need to time your purchases to coincide with market movements that will lead to a price increase. Short selling, on the other hand, involves timing sales to occur during market declines that will lower prices.
- Risk: Both types of trading involve risk, but short selling poses an additional risk because the price may rise significantly and unlimited losses could result.
- Strategy: There are many different ways to trade traditionally, including long-term investing, day trading, and swing trading. The primary purpose of short selling is to make money in the short term.
- Borrowing: To sell short, investors must borrow assets from a broker or other financial institution, which adds to the costs and risks associated with short selling.
- Market Dynamics: The effects of short selling on the market are different from those of traditional trading. When a stock price is widely shorted, it can lead to further declines in value as a result of downward pressure from short selling. Alternatively, traditional buying can increase the price of a stock.
To succeed in short selling, you need a high level of skill and experience, as short selling is a more complex and riskier trading strategy than traditional trading.
Short Selling Financial Assets – How to do it?
Before initiating a trade, it is advisable to determine the entry and exit points as well as consider implementing a stop order to minimize losses in case the trade goes against you. There are two types of stop orders that can be beneficial:
Buy-stop orders: A Buy-stop order activates a market order to buy back the shares at the next available price when the stock price reaches or surpasses the stop price.
Trailing buy-stops: Trailing buy-stops set a stop price that “trails” the lowest stock price by a percentage or dollar amount that you specify. When the stock price exceeds its lowest price by the trail or more, it triggers a buy market order. If the price decreases, the stop is reset at a lower price.
Nevertheless, neither of these methods ensures that the order will execute at or near the stop price you indicate, and in some cases, the stop loss order could cause significant losses if the price jumps up.
Suppose you're considering trading stock XYZ, which recently experienced a drop from $90 to $66 per share, followed by a rebound to $84. If you believe the stock is likely to decline again, you may develop a trade plan after researching the company's fundamentals and analyzing recent price movements. Your plan might involve: *You should only enter a short position if the stock price is below $80. *You should place a buy-stop order at $84 per share in order to limit your potential loss to $4. *If you are holding a position at or below $74 per share, close it out at that price.
What are the Short Selling Metrics?
Two short-selling metrics are primarily used by traders to determine whether a security is overvalued or likely to decline in value in the near future. They are as follows:
- Days to cover ratio – Also called the short interest-to-volume ratio, it measures the correlation between the number of securities with short interest and the volume of their trading. It gives an indication of how well a security is performing based on its demand. Consequently, a high ratio indicates a bearish trend for a security.
- Short interest ratio – This statistic indicates the ratio between the number of shorted securities and those that are afloat in the market. If the ratio is high, it indicates a high level of short interest and a substantial probability that the price of the security will fall in the future. Conversely, high short interest ratios also increase the likelihood of a short squeeze.
How to Short Sell Stocks?
Short selling stocks involves borrowing shares of a stock from a broker and selling them in the market in hopes of a price decline. Here’s how to short sell stocks:
- Choose a broker that offers CFD trading: Look for a reputable broker that offers CFD (Contracts for Difference) trading. Stock CFDs allow traders to speculate on stocks without owning the underlying securities.
- Open a trading account: Open a trading account once you have selected a broker. It will require some personal information and verification.
- Fund your account: To open a position, you’ll need to deposit funds. You can take a position based on the amount you deposit.
- Identify the stock you want to short: Find the stock you want to short on your broker’s platform. Look for stocks that are overvalued and likely to decline.
- Place your short sell order: Select the stock you wish to short sell and place a short sell order. It involves borrowing shares of stock from the broker and selling them.
- Monitor your position: Keep an eye on your shorted stock’s price movement. You might have to add more funds to your account if the price rises. You can make a profit if the price drops and you sell the shares back to the broker.
- Close your position: Return the shares to the broker when you are ready to close your position. When prices fall since you opened your position, you profit. You will lose money if the price has risen.
Stock prices can rise as high as they want, making short selling a risky trading strategy. Traders should only short sell stocks if they are fully aware of the risks.
How to Short Forex Currencies?
Short selling a currency on the foreign exchange market means selling a currency pair with the expectation of the base currency declining in value. Here’s how to short forex currencies:
- Choose a currency pair: Decide which currency pair you want to short. Consider forex pairs with a weaker base currency compared to the quote currency.
- Open a trading account: Open a forex account with a broker that offers short selling. Make sure the broker is trusted and regulated.
- Sell the currency pair: Posting a sell order once you have opened an account allows you to sell the currency pair. Sell the base currency and buy the quote currency.
- Monitor the trade: Once the trade is open, you need to keep an eye on it to make sure it is going well. In case the trade moves against you, consider setting a stop-loss order.
- Close the trade: You can close the trade by placing a buy order when you are satisfied with your profits. It involves buying back the base currency and selling the quote currency.
A forex trader should have a thorough understanding of the market before shorting currencies. An effective trading strategy and risk management are important.
How to Short Cryptocurrencies?
Shorting cryptocurrencies refers to borrowing a certain amount of the currency and then selling it at the current market price in the hope that it will decline in value. As soon as the price drops, the investor can buy back the cryptocurrency, return the borrowed amount, and keep the profits. Here are the steps to short selling cryptocurrencies:
- Create an account with a cryptocurrency exchange or brokerage that allows short sales. This service is not available on all exchanges.
- Make the required deposit of cryptocurrency or fiat currency.
- Short cryptocurrency by borrowing it from the exchange or brokerage. There will be margin requirements depending on the platform.
- Make a sale at the current market price of the borrowed cryptocurrency.
- Be patient and wait for the price to drop.
- Repurchase the same quantity of cryptocurrency for less money.
- You must return the borrowed cryptocurrency to the exchange.
- Your profit is the difference between the price you sold and the price you bought back.
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How to Short Gold Prices?
Short selling gold means you’re betting against gold’s price and expecting it to drop. To short sell gold, you borrow gold from someone else, sell it, and then return it to the lender at a lower price. Here are the steps to short sell gold:
- To short sell gold, you’ll need a brokerage account that lets you trade CFDs, futures, and contracts. Invest in these types of investments with a reputable broker.
- The XAU/USD pair is the most popular pairing that forex brokers offer, making it easier than ever to incorporate gold as part of your trading strategy. Instead of buying gold physically, traders can speculate on its price and gain profits from it.
- Keep an eye on gold prices. Consider holding onto your position if the price drops further. Consider exiting your position if the price starts to rise.
- You must buy back the same amount of gold you sold earlier when closing out your position. If you sell it for a lower price than you bought it for, you will profit. However, if the price goes up, you’ll need to buy back the gold at a higher price than you sold it for, resulting in a loss.
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Fundamentals of Short Selling Financial Assets:
Even though short selling seems straightforward, there’s a lot more to it than just understanding the concept, and serious losses can result from the strategy.
Here are some fundamentals of short selling:
- Borrowing: The trader must first borrow the asset they intend to sell short before executing a short sale. Usually, a broker or another financial institution is used for this.
- Selling: The trader sells the asset after he or she has borrowed it in order to repurchase it at a lower cost.
- Technical analysis: Technical analysis helps short sellers identify potential opportunities to profit from declining stock prices by studying charts, historical price patterns, and technical indicators.
- Risk: Since the asset’s value could increase at any time, short selling carries a significant level of risk. If traders are unable to repurchase assets at a discount, they risk losing a sizable sum of money.
- Margin: When short selling, you frequently borrow money from a broker so that you may place the trade. Short selling is therefore a high-risk, high-reward technique with a significant chance of loss.
- Fundamental analysis: Fundamental analysis is crucial for short sellers as it helps identify overvalued or weak stocks. By analyzing financial statements, industry trends, and economic factors, short sellers can predict declining asset prices and make informed decisions.
- Timing: To successfully short selling an asset, the trader must be able to accurately predict when the item’s price will fall. This means they must be able to decide when to sell the asset. This tactic heavily entails market investigation and evaluation.
- Costs: Short selling entails a range of trading expenses, including broker fees and interest charges for borrowing the asset.
Only experienced traders with a thorough awareness of the risks should attempt the sophisticated trading method known as short selling. The approach should never be utilized as an exclusive means of making investments; rather, it should be used to augment a diversified portfolio of investments.
Risks associated with Short Selling
Short selling carries the biggest risk of potential unlimited losses, as opposed to traditional stock purchases where losses are limited to the amount paid for shares but gains are theoretically limitless. When short selling, gains are capped at the total value of the shorted stock if the stock price falls to $0, but losses can accumulate indefinitely as the stock price rises.
For example, if you borrow and sell 10 shares at $10 each, generating $100, but the shares rally to $50 or $100 each, you may have to buy them back at a loss of $400 or $900, respectively. This risk can continue indefinitely, and the longer you wait for the stock price to fall, the more you'll pay in interest on the borrowed shares. If the losses become too great, a margin call may be issued, and the short-seller may be required to put up more collateral in the account or close the position by buying back the stock.
Due to the market’s tendency to rise over time, short selling can be challenging to achieve consistent profitability, and the risk is generally higher than with a buy-and-hold strategy, especially for inexperienced investors.
Guidelines for Short Selling:
A wrong guess about price movement can cost a seller money when short selling. Here are some guidelines to follow when short selling:
- Identify your Asset: To successfully short sell, it is critical to select assets that are overvalued, have questionable fundamentals, or are declining in value.
- Know your Margin: To hold a short position, an investor must maintain sufficient equity in their account to act as collateral for the investment margin, which is typically at least 25% per exchange regulations. However, brokerage firms may set higher minimums depending on the risk associated with the security and the investor’s total holdings. Short positions can be held for any duration but remember that interest is charged on borrowed shares throughout and margin requirements must be met.
- Set stop-loss orders: Stop-loss orders are the best way to limit your losses when short selling a trade. To avoid significant losses if the asset’s value increases unexpectedly, short sellers need to set stop-loss orders.
- Understand the costs: If the asset price decreases, the investor can close the short position by purchasing the borrowed shares at a lower price and returning them to the brokerage. It should be noted that to earn a profit, the investor must take into account the interest, commission, and fees that they will be charged. Here’s how to calculate the trading costs, such as Spread, Commission and Swap fees.
- Stay disciplined: Short selling can be a difficult and emotionally taxing tactic. To prevent making foolish judgements that could result in big losses, it is imperative to maintain discipline and adhere to a well-thought-out plan.
The most important aspect of short selling a financial asset is to understand the mechanics as well as to practice the strategy before you commit real money to it. One way to practice short selling tactics is by using a demo account.
Short Selling: FAQ
What is short selling and long selling?
Short selling and long selling are two investment strategies on the financial markets. Long selling involves buying an asset with the expectation that its price will increase, while short selling involves borrowing shares and selling them with the expectation that the price will decrease, buying them back at a lower price and returning them to the broker for a profit.
Is short selling profitable?
Short selling is when traders borrow and sell a company’s shares in the hope of buying them back at a lower price later on. If the share price does indeed fall, the trader can make a profit by buying the shares back at the lower price and keeping the difference. But if the share price goes up, the trader will lose money.
What is an example of a short selling?
Suppose you borrow 100 shares from your broker and sell them at $50 per share in the current market. Two weeks later, the price of XYZ stock drops to $40 per share, so you buy 100 shares for $4,000 and return the borrowed shares. This scenario results in a profit of $1,000 ($5,000 – $4,000), excluding fees. However, if the stock price had risen instead, you would have lost money.
What is the risk of short selling?
1. Asset behavior cannot be predicted all the time
2. Margin calls can require additional funds or liquidation at a loss
3. Short squeeze can force buying back shares at higher prices
4. Limited profits to the price of the sold shares
Can short selling drive down a stock’s price?
When many short sellers are focusing on the same stock, short selling can occasionally cause a stock’s price to decrease. Short selling is not likely to be the only factor in a stock’s price decline, though.
Is short selling legal?
Yes, short selling is legal in most countries but subject to regulations and restrictions. However, it can be risky and lead to unlimited losses if the security price rises. Regulatory authorities impose rules such as disclosing short positions, restricting timing and duration of sales, and sometimes banning short selling during market stress.