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Lesson 13: Short Selling

Lesson 13: Short Selling

Short selling is a popular trading technique for investors with a lot of experience. It can create large profits. But it also involves the potential to lose a lot of money.

There are various ways to short a stock. In this guide, we investigate what is short selling, how it works, and key signals when deciding what stock to short. Shorting stocks is more complex than trading based on optimistic market attitudes. Therefore, it is important to understand how to sell short and the implications of doing so.

How to use this guide:

  • Understand how to short sell and which method is best for you.
  • Open a demo account and practice short selling with virtual funds
  • When ready open a live trading account to take advantage of share prices that are expected to decline.

What Is Short Selling?

Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price. It is an advanced strategy that should only be undertaken by experienced traders and investors.

With conventional stock investing, you would buy shares that you believe have a positive outlook and the potential for growth – this is known as ‘going long’ or taking a long position. When you short sell or ‘short’ stocks, you’re looking to do the exact opposite. Short sellers identify shares or markets that they think might be poised for a downswing.

Investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Traders may use short selling as speculation, to benefit from bear markets. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.

The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.

How does stock short selling work?

Unlike most traders who like to buy low and sell high, short-sellers adapt the order of this philosophy and aim to sell high and buy low. Stock short selling is a complex topic, and there are many things to be mindful of when shorting a stock. There are a variety of methods that can be used to short sell stocks, including share dealing, derivatives, and options trading.

To make things easier to understand, let’s say that Lucid Motors shares are currently trading at $20 per share, which you think is overvalued. In anticipation of the share price falling, you decide to short the stock. The outcome would depend on your chosen method of shorting:

Traditional short-selling

When shorting a stock via a traditional method, traders borrow shares they do not own. These shares are usually lent from their financial broker. The trader then sells the borrowed shares at market value. The trader aims to repurchase the same shares at a lower price and return the shares to the lender. If the price of the stock drops, short-sellers profit from the difference in price between the rate they borrowed at, and the rate they repurchase the shares.

This is typically a practice of large institutions rather than individual investors, but some brokers will facilitate short selling.

Example of Traditional Short Selling

Let’s say that you borrow 100 Lucid shares via your broker and then sell them at the current market price of $20 – taking $2000 from the sale. It is worth noting that you would likely need to pay a fee to borrow stock to short sell. The shares do fall in price as you predicted, down $2 to $18 per share, and you buy 100 shares back at the new, lower price, for $1800. You then return them to your broker to close the trade and keep the $2 difference per share. You would have made a $200 profit (minus any brokerage fees and dividend costs that are owed).

However, if your prediction was wrong and Lucid Motors' stock price increased by $2, you might decide to close your trade to cut your losses. In that case, you’d have to buy the shares for '$2 more than you sold them for – incurring a $200 loss (again before accounting for the borrowing costs and dividends that you would still need to pay).

Derivatives trading

Derivatives are financial instruments that take their price from the underlying market. With derivatives, such as CFDs, you haven’t had to borrow shares from a broker – you are simply speculating on the market price rather than taking physical ownership of the asset.

CFD trading is available globally, providing an efficient method to short stocks from most countries. CFD traders speculate whether they believe the market will fall or rise, receiving profit for correct speculations and incurring a loss for incorrect predictions.

With CFD trading, you are agreeing to exchange the difference in the price of your chosen asset from when the position is opened to when it is closed. When you short-sell a CFD, you open a position to ‘sell’ the asset.

Example of short selling stocks with CFDs

For example, let us say that you wanted to short the popular US stock Lucid Motors (LCID) via CFD trading.

You open a position to “sell” 100 share CFDs at $20. Your total market exposure is now $2,000.

CFDs are leveraged, meaning you only need to pay a deposit of the full trade amount to open the trade. The margin rates for shares are 20%, meaning you have to deposit $2000 x 20% = $400 margin requirement.

If the market did fall as you’d predicted, you would close your position by buying 100 shares at the new price of $16. You would then calculate the difference between the opening price and closing price, and profit from the difference: in this case, $20 – $16 = $4 x 100 shares = $400.

However, if you had been incorrect and the market increased in price, up to $23, you would have to buy 100 shares at the new market price. This would incur a $300 loss ($2000 - $2300 = $300 loss).

Note that any outcome to a CFD trade is calculated using the full value of your exposure, not just the deposit, which means that profits or losses can be magnified.

With CAPEX you can trade up to 2.000 CFDs on shares and unleveraged, fractional shares with no commission or swap costs.

How to find stocks to short sell

Finding the right time to short a stock can be the difference between good and bad short selling. Generally, it is dependent on a trader’s strategy to find effective market entry and exit points. Our guide to stock market trading hours will also help you to determine the right time of day to place a trade. Most traders will use a combination of strategies to determine when they will enter the market, but it varies distinctly between technical analysis and fundamental analysis.

Technical analysis

Technical analysts could short a stock based on what direction the general trend is heading. Using simple trend line indicators, technical analysts would analyze the trend direction of a share of stock. If the trend showed no signs of slowing down, it would present a key opportunity for technical analysts to ride the trend downwards.

Technical indicators such as Ichimoku, MACD, RSI, or moving averages can provide key insight for technical analysts. Stocks that drop through prominent support points (Fibonacci retracements, pivot points), or fall below major moving averages may continue on a descending trend.

Japanese candlestick chart patterns can provide valuable short selling signals, as well as western chart patterns like head and shoulders top, descending triangles, rising wedges, or double and triple tops.

Fundamental drivers

Missed earning reports present a big opportunity for short-sellers. If a company's profit does not meet profit estimations, it is likely to be underperforming in certain areas. This could cause a large number of investors to start short selling. However, it is often best to look beyond just earning reports, as a company may be underperforming for reasons that do not impact its stock price.

Declining industries provide another opportunity for short-sellers. Industries that have experienced a general downturn due to innovations in other markets or negative client sentiment can cause a particular stock’s price to plummet. This can also be affected by political and economic events such as presidential elections and trade wars. When an industry is perceived as obsolete, companies in that competitive space can be left with dwindling growth prospects, causing short sellers to take advantage.

Overvaluation is a common factor that can cause short sellers to come together. Stocks that are constantly covered in the news can cause the price to hyper-inflate relative to the stock's actual value. Once the stock market bubble bursts, short sellers will come together knowing that the stock is not worth its current market value.

However, please note that a stock’s fundamental values are not the sole determinants of its price. There are various factors to consider when shorting a stock, and these factors form a complex picture. Each trader should do their own research when considering trading stocks.

Benefits of shorting a stock

  1. Hedging risks. Using short selling to offset the risks of other assets in your portfolio is a known strategy for savvy long-term investors. Hedging your other positions by short selling can reduce your overall risk exposure. Say, for example, you purchased NIO shares and intended to hold them for 10 years to profit from the company's expected growth. If any short-term disruptions impacted the rising trend of NIO share price and it started to fall, you could hedge your investment position by short selling. This way, any losses that exist for NIO's shares can be reduced by the profits of the short sell.

  1. Opportunity. Most financial markets are volatile and sensitive to external forces. Having the opportunity to take a position on both sides of the market can be more useful than only having access to buying opportunities.

  1. Market crashes and recessions. Short selling is a form of short-term trading (scalping, day trading or swing trading) that provides one of the few opportunities to profit from falling stock markets and recessions. Without having the ability to short a share, profit opportunities would be limited to periods of market growth.

Risks of shorting a stock

  1. Limited profit and unlimited loss. When shorting a stock through a broker the maximum profit you can make is limited as a stock cannot surpass being worthless. Additionally, losses can be hypothetically unlimited as there is no limit to a rising stock price. However, when leveraged trading, the use of stop-loss orders can be used to manage this risk.

  1. Short squeeze. When a group of short-sellers makes an incorrect decision to short a stock, they can panic and sometimes buy back the stock they were shorting. This increase in market activity can cause buying pressure that pushes up stock prices. Losses are realized for short-sellers when the market turns in the opposite direction of what they suspected. This process is referred to as a short squeeze.

Short Selling Cryptocurrencies

During 2018, increased regulations and a general slowdown in cryptocurrency trading caused the bitcoin price (BTC) to shed over 80% – falling from over $17,000 in January to a low of $3152 in December. While the sell-off was catastrophic for some, for others the cryptocurrency fall was a short-sell opportunity.

What is bitcoin shorting?

Bitcoin shorting is the act of selling the cryptocurrency in the hope that it falls in value and you can buy it back at a lower price. Traders can then profit from the difference in market price. Short-selling takes the typical mantra of ‘buy low and sell high’ and flips it on its head – while you still buy low and sell high, the trader sells the asset first and buys it back later.

When you trade cryptos via CFDs with us, you get exposure to these assets, while retaining good liquidity and the ability to short sell. Also, you don't need a wallet and don't have to worry about losing your key. Your focus always remains on your trading!

Short Selling Commodities

To ‘short’ (sell, or short-sell) a commodity means that you’re betting against the price of raw material, such as oil or gold. In other words, you think that the market price will fall. If you’re right, you will make a profit, but if the market price rises, you’ll make a loss.

For example, if you think that some events may cause demand concerns for Oil, you can open a short position and profit from falling oil prices.

So, how do you short a commodity? The good news is that you don’t have to own any physical materials to do this. Commodity shorting can easily be done via derivatives such as contracts-for-difference or futures contracts, which enable you to speculate on price movements. One of the benefits of CFD trading is that you can trade using leverage. This means you only need a small deposit to open a position, while still getting exposure to the full value of the trade. However, your profit and loss will be based on the full position size.

What is gold shorting?

Consider this gold trading example: gold is trading at 1494.05 with a sell price of 1493.90 and a buy price of 1494.20. Because you think the price of gold is going down, you want to short the market using a CFD. So, you short ten contracts at the sell price of 1493.90.

Summary

  • Short selling is the practice of borrowing shares, in order to sell them at the current market value and buy them back once the market has declined – profiting from any difference in price
  • Shorting can be used for hedging and speculative purposes
  • The traditional method of short selling involves borrowing stocks that you do not own, usually via a stockbroker
  • The most popular alternative method of short selling stocks, but also commodities or cryptocurrencies includes CFD trading
  • If the underlying market price dips, you could make a profit.
  • There are risks involved in short selling, such as unlimited loss or being caught in a short squeeze.

If you want to practice short-selling stocks in a risk-free environment, you can open a demo account with CAPEX.com and start testing your CFD trading. Or, if you feel ready to start short selling stocks on live markets, you can open an account and be ready to trade in less than five minutes.

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