Short Selling Trading Technique Explained

July 27, 2023
10 MIN READ
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Short selling happens when a shareholder borrows an asset and sells it on the open market, intending to repurchase it later at a lower price. Short sellers gamble on and profit from a reduction in the price of securities. Long investors, on the other hand, want the price to rise. Short selling has a high risk/reward ratio: it can provide large gains, but losses can swiftly and indefinitely build owing to margin calls.

What is short selling?

A short sale is an investing or trading technique that bets on the price of an asset or other security falling. It is a sophisticated method that seasoned traders and investors should only attempt.

Short selling can be used as speculative trading by traders or as protection against the possible negative consequences of a long position in the same or related securities by traders or portfolio executives. Speculation is a sophisticated trading approach with the potential for significant risk. Hedging is a typical transaction in which an offsetting position is taken to lessen risk exposure.

Short selling involves borrowing shares of an investment, such as an asset that a shareholder believes will fall in value. After that, the financier sells the borrowed stock to purchasers ready to pay the market value. Before the borrowed shares have to be returned, the trader is wagering that the price will continue to fall and they will be able to acquire the shares at a reduced cost. Because the price of any asset might rise indefinitely, the risk of loss on a short sale is potentially endless.

The concept of short selling

A seller establishes a short position by borrowing stakes from a broker to buy them back for a monetary gain if the price falls. Shares must be borrowed since it is impossible to sell assets that do not exist. To terminate a short position, an investor buys the stock back on the market (ideally at a lower price than when the asset was borrowed) and delivers them to the creditor or brokerage. Dealers are responsible for any interest or charges levied by the agent on trading.

To initiate a short position, an investor requires a margin account and must normally pay interest on the borrowed stock while the position is active. Furthermore, the Financial Industry Regulatory Authority (FINRA), which implements the laws and ordinances regulating registered agents and brokerages organizations in the United States, as well as the New York Stock Exchange (NYSE) and the Federal Reserve, have established a minimum threshold for the sum that the margin account has to uphold (known as the maintenance margin). Extra money is needed if a shareholder's account worth declines below the maintenance margin, or the broker may sell the investment.

The broker handles discovering shares that may be borrowed and delivering them behind the scenes at the deal's close. Numerous brokers' conventional trading interfaces allow for the opening and closing of trades. Nevertheless, before allowing margin trading, every agent will have certain requirements that the trading account must satisfy.

Why should you sell short?

Short selling is most commonly done for speculative and hedging purposes. A speculator is betting solely on the price falling in the future. If they are incorrect, they will have to repurchase the shares at a higher price, at a loss. Because of the added risks associated with short selling owing to the usage of margin, it is frequently undertaken over a shorter period. It is thus inclined to be a speculative activity.

Short sales can also be used to protect a long position. For example, if you possess call options (long positions), you might like to sell short to secure gains. You can also sell short in an asset closely tied to or highly associated with it to prevent prospective losses without quitting a long stock investment.

The benefits and drawbacks of short selling

Selling short can be expensive if the vendor predicts the price trend incorrectly. Investors who have purchased holdings can only forfeit their entire investment if the stock falls to zero.

On the other hand, an investor who has shorted an asset may lose considerably more than their initial investment. The risk arises because the security price is unlimited; thus, it can increase "to infinite and higher" to use a term from the comic character Buzz Lightyear. Furthermore, the investor had to support the margin account while the equities were held. Even if everything goes perfectly, traders must account for the margin interest cost when computing earnings.

When completing a position, a short seller may have difficulty locating enough shares to buy if other investors heavily short the company or are lightly traded. On the other hand, sellers may become trapped in a short squeeze cycle if the market or a specific stock begins to surge.

On the contrary, approaches with high risk also have a high payout. Short selling is no different. If the seller properly guesses the price movement, they can earn a nice return on investment (ROI), especially if they employ leverage to begin the deal. Applying margin gives leverage, which implies the trader did not have to put up much of their starting cash. When done correctly, short selling may be an affordable hedge strategy, giving a counterweight to other portfolio positions.

Novice traders should avoid short selling until they gain more trading expertise. However, short selling through exchange-traded funds (ETFs) is a little safer technique due to the decreased danger of a short squeeze.

Additional factors to consider when selling short

Aside from the risk mentioned above of losing cash on a deal due to the price of a security increase, traders should be aware of extra hazards associated with short selling.

·       Borrowed funds are used in shorting

Margin trading is another term for shorting. If you short-sell, you create a margin account, enabling you to borrow money from a broker-dealer business and use your investment as security. Losses can quickly mount when you go long on margin since you must fulfill the lowest possible maintenance obligation of 25%. If your account falls below this level, you will be exposed to a margin call and compelled to put more money in or liquidate your investment.

·       Bad timing

Even if a firm is overpriced, its shares may take some time to fall. Meanwhile, you are exposed to being called away, interest charges, and margin calls.

·       Short squeeze

If a stock is aggressively shorted with an elevated short float and days-to-cover ratio (shown below), it is also vulnerable to a short squeeze. A short squeeze occurs when an asset increases, and short sellers cover their holdings by purchasing them back. This purchasing might become a feedback cycle. Demand for the shares draws more purchasers, increasing the price and prompting even more short-selling traders to purchase back or cover their holdings.

·       Regulatory constraints

Regions may occasionally prohibit short sales in a certain sector or market to minimize panic and undue selling pressure. Such measures might trigger a sharp increase in stock prices, causing short sellers to cover their holdings at a significant loss.

·       Going against the flow

In general, history has proven that stocks tend to rise. Most equities improve in value over time. Even if a firm hardly improves over time, inflation or the pace of price growth in the economy should cause its stock price to rise slightly. This indicates that shorting involves betting against the market's general direction.

Short selling charges

Short selling, as opposed to purchasing and keeping stocks or assets, entails hefty charges in addition to the standard trading commissions that brokers must pay. Among the expenses are:

·       Interest on margin

When making stock trades on margin, margin interest can be a major expenditure. Because short sales may only be executed through margin accounts, the interest required on short transactions can quickly pile up, especially if short positions are held open for an extended time.

·       Costs of share borrowing

Stocks that are challenging to borrow due to heavy short interest, low float, or any other cause have "hard-to-borrow" charges that can be fairly expensive. The charge is adjusted for the number of days the short trade is active and depends on a yearly average that may vary from just a portion of a percentage to greater than 100% of the worth of the short transaction.

Because the hard-to-borrow rate can vary significantly daily, even during the day, the precise dollar amount of the charge might not be determined beforehand. The charge is normally applied to the customer's account at the end of each month, or when the short transaction is closed—and if it is extremely considerable, it can significantly reduce the earnings of a short trade or compound losses on it.

·       Other payments and dividends

The short seller is liable for making dividend payments on the shorted shares to the organization that borrowed the shares. The short seller is also liable for unexpected payments resulting from additional events related to the shorted stock, like spinoffs, share splits, and bonus share issuance.

Both short-selling measures assist traders in determining if the overall sentiment for a company is bullish or negative.

Conditions favorable for short selling

When it comes to short selling, timing is vital. Stocks often fall far quicker than they rise, and a significant gain in stock can be erased in a matter of days or weeks due to an earnings miss or another unfortunate occurrence. As a result, the short seller must time the short transaction to near flawlessness. Starting a transaction too late could result in a significant opportunity cost regarding missed earnings, as a significant portion of the stock's fall may already have occurred.

Joining the trade too soon may make it challenging to maintain the short position due to the fees involved and possible losses, which would rise if the stock rose swiftly. 

There are several instances when the chances of an effective shorting increase, like:

   i. During a downturn/bear market

During a bear market, the primary tendency for an asset market or sector is downward. Traders who think "the trend is your friend" have a higher chance of executing effective short-sell bets during a deep bear market than during a strong bull market. Short sellers thrive in market declines that are quick, broad, and deep since they will benefit handsomely.

   ii. When the fundamentals of investment are declining

A company's basic concepts might worsen for various reasons, including slowed earnings or profits growth, increased business problems, growing input prices that pressure margins, and more. Worsening fundamentals might include a string of poorer data points indicating a likely economic slowdown, negative geopolitical developments such as a danger of war, or bearish technical signs such as new highs on declining volume and worsening market breadth.

Skilled short sellers may place short transactions after the negative trend has been verified rather than anticipating a downward move. This is due to the potential risk that, in the late phases of a bull market, a company or market may move higher for weeks or months despite worsening prospects.

   iii. Economic signals confirm the bearish pattern

Short sales may also have a better chance of success if various technical indicators corroborate the negative trend. A collapse below a critical continuous assistance zone or a negative moving average crossing, such as the death cross, might be examples of these signs. A moving average is a security's price over a given period. If the present cost breaks the average downward or upward, it may indicate a new price trend.

Conclusion

Short selling enables traders and shareholders to profit from a declining market. Those who are bearish might borrow stock on margin and sell them in the market, expecting to buy them at a lower price later. Although critics have condemned short selling as a market gamble, many economists argue that the option to sell short makes economies more effective and may even function as a stabilizing influence. Technical investors and analysts frequently use short interest and other metrics concerning short positions to influence trading ideas. Margin calls, on the other hand, can squeeze huge short holdings.