Short selling – what is it and when to use it

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Short selling is a popular strategy used by many investors. After the stock market crash in 2008, probably everyone heard about this issue. However, how does it work in practice and when should it be used?

Each of us is aware that the key to making money on the stock market is the maxim: „Buy cheap, sell high”. Unfortunately, this is not always possible. So what to do when the market is in a downtrend and prices just are not rising? Then short selling offers the greatest earning potential.

What is short sale

Short selling is a well-known strategy to make a profit on the stock exchange from a decline in asset value. As defined in the Act on Trading in Financial Instruments, short selling is an obligation to sell securities that are not recorded on the investor’s account on the date of the sale agreement.

A trader decides to trade when he believes that the price of a given instrument on the market will be lower and lower. He then intends to profit from such a move by opening a „sell” position (called a short position) instead of a „buy” position (known as a long position). This means that the investor anticipates that the price of a given financial instrument will go down and the market is in a bearish or temporary correction phase.

Short selling – the mechanism of action

Short sellers borrow assets to sell at the current price today, but don’t pay for them until prices change, thereby keeping the difference to themselves. In the event of a drop in price, the investor, in order to return the borrowed assets, buys them back on the market at a lower price than he sold and thus earns money. If the price rises, the trader will lose.

Most often, a security is borrowed from a broker. Closing and opening positions can be done through most trading platforms. The underlying instruments on which we make a short position may be:

  • Currency pairs (Forex market)
  • Goods
  • Stock indices
  • Actions

The short selling mechanism is definitely the best for CFDs, because with the use of financial leverage we can quickly maximize profits, especially if we do not expect a downtrend, but only a short or medium-term correction.

Short sale – an example

Imagine the investor expects Company X’s share price to fall. Currently, the price per share is $ 100. The trader is making a short sale of 50 shares of company X at the current price. This means that the investor borrows these 50 shares from the broker and sells them to another investor. After some time, he decides to buy back the shares. Did he make a profit in this way? We have 2 scenarios:

  1. Company X’s share price has indeed dropped and is now trading at $ 80. As a result, the trader recorded a profit of $ 1,000 [($ 100- $ 80) x 50] minus commissions and interest.
  2. The share price of Company X rose to $ 130 against the trader’s expectations, so in order to avoid further losses, he decided to close the short position. He then suffered a loss of $ 1,500 [($ 130 – $ 100) x 50] and incurred additional commission and interest costs.

If an investor wants to sell a short share of this company, but in the form of a CFD , instead of directly on the market, he can do so on the trading platform with the selected broker.

Such a transaction will take place with the use of leverage, which means that the investor will not have to enter into a short position of such high value to achieve the same effect. For example, with a leverage of 1:10, it is enough to short sell 5 contracts on shares of company X, i.e. invest $ 500 instead of 5000 and the profit or loss will be almost the same, you only need to add the spread costs with the broker.

Short selling and its advantages

Of course, the biggest advantage of short selling is achieving high profits in a relatively short time . The easiest way to do this is by investing in CFDs with the use of leverage. In this situation, you do not need a large start-up capital to start investing using a short selling strategy.

Often, traders also use short selling as a way to hedge a position in a long-term strategy. They then decide to hold an open profitable long position because they assume that the price of the security they are buying will continue to rise. However, if it does decline, the gains in the short position partially mitigate their losses.

It should also be added that thanks to the increasing popularity and availability of short selling, the investor has an easier opportunity to examine the mood on the market. It is also true that it provides greater liquidity and can prevent investment bubbles – some traders tend to reasonably tone down any hyper-optimism about an asset.

Disadvantages of short selling

It should be noted that with a short sale, the investor is exposed to much greater losses than with classic investing. The risk is basically endless as there is no limit to the price of stocks, they can always go up. Therefore, it is worth paying special attention to the analysis of a given security before taking a short position and that the deposit contains a large reserve of funds.

Among experienced investors, a phenomenon called short squeeze is also noticeable on the market . It occurs when some of the traders who own the actual shares of the company notice a relatively large amount of short selling in relation to the turnover. In such a situation, the aforementioned investors refrain from selling their shares, which has a negative impact on the market liquidity.

With unchanged demand, this leads to a significant surplus of buyers over sellers, which results in a sharp increase in the price of a given share. This causes traders selling short to close, which drives the price up even more.

When is it worth selling for a short time

Of course, no one is sure what will happen on the market in the future. However, from time to time there are signals pointing to short selling as the best option.

The first example of this type that comes to mind is the specter of a financial or economic meltdown . If the media start to panic and suggest a collapse of a given market, taking a short position can bring really high profits.

Another signal is the scandal concerning the given company. Such situations happen much more often and foreshadow severe price drops. Example? In 2018, the German concern Bayer AG bought the controversial company Monsanto. Since then, there have been many scandals related to the purchased company, dozens of new lawsuits accusing it, Bayer has often been forced to pay even fines, even in the amount of USD 2 billion, and the price of the German concern on the stock exchange has been systematically dropping.

Another situation suggesting the legitimacy of short selling is the gradual deterioration of the financial reports of a given company . If it brings less profits over time (or they are much lower than originally assumed) and turnover is declining, its stock market price should also decline. This is also a fairly common situation on the market. An example of such a phenomenon was the decline in Netflix by 12 percentage points, which took place on July 18 last year. It was the first session after the company presented data on the number of subscribers, the number of which, to the great surprise of investors, decreased in the second quarter of 2019.

Short selling – when it’s not worth it

Short selling should definitely be avoided if:

  • The company has clearly favorable results from the fundamental analysis
  • Technical analysis shows a strong uptrend
  • A company’s share price has fallen sharply and significantly recently

Short selling – is this a good strategy?

You can often find unflattering opinions about short selling on the Internet. In my opinion, this strategy does not deserve such a bad name. Of course, it requires close attention when it comes to the technical, fundamental and current price of the instrument. If, after carefully considering these guidelines, you believe that the price will be falling, there is nothing to prevent you from going short.

There is increasing volatility in the financial markets. In the current times of QE programs or negative interest rates, it is often manifested by dynamic declines. This offers more opportunities for the trader to make profits, especially as on trading platforms with most brokers, opening a short position on CFDs is lightning fast.

However, it should be remembered that investing using short selling carries an increased risk of suffering huge losses. Therefore, I recommend beginner traders to practice short trading on a demo account first, most brokers offer this option. It’s best to learn how to trade right away on the most popular universal MetaTrader 4 and 5 platforms.