Recently you have certainly heard the term short-selling being bandied about more than usual. So, what exactly is it? First, it is a trading technique that requires traders to take a bearish stance on an asset. This goes against the common wisdom of buy low and sell high. However, this traditional trading style applies when the market is going up, but short-selling occurs when the market is going down. Instead of buying low and selling high, you sell high and buy low. It is based on the view that the stock is overvalued and therefore will drop in price. Consequently, traders make a profit on the price change margin. This way, traders can benefit from the stock market regardless of the trend. In this article, we go over the basic concepts of short-selling and the different ways traders use it.
How Short-Selling Works
First, you need to know that practicing short-selling techniques often requires the use of a mathematical formula. Don’t fret, it is relatively simple. The concept behind it is that the lower the repurchase price of your shares relative to your selling price, the more profit is made. So, the lower the price of the stock sold short, the higher the gains. And the formula is:
(Sell Price – Purchase Price) x Number of assets – Transaction Cost = Profit
If the result is positive then the trader has realized a gain, but if it is negative, there is a net loss.
The Best time to Short-Sell
Short-selling is not a trading technique to be used in regular times. While no one can predict the future, some scenarios are more adapted to short-selling. And these are during a financial crash, a deep crisis, a sudden business scandal that drops the stock price, or a quarterly earnings miss.
Markets To Trade a Short Position
- Foreign Exchange
Popular Stocks for Short-Selling
Different Short-Selling Strategies
While the maximum profit that traders can expect from short trading is the equivalent of the price of the asset at the time of the opening of the trade, there are different strategies to achieve this. The very concept of short-selling implies a speculative approach for the short and medium terms. Therefore, in order to get the best profit margins, explore available techniques.
A Short Squeeze
A squeeze on the stock market is when the prices jump higher suddenly following an event or announcement. This change forces traders who had bet that the price will fall to buy it in order to avoid further losses. This will only add upward pressure on the stock. Contrarian investors try to anticipate a short squeeze and buy stocks that show strong short interest. This is a risky move. Wise investors would always have additional reasons for a short trade.
Risks, Rules, and Restrictions
Short-selling has significant risks but there are ways to avert common pitfalls and avoid drastic setbacks:
- Put a Stop Loss on sell orders
- Use volatility protection tools
- Choose a broker with negative balance protection
In many cases using risk management tools and features such as Stop Loss is the most efficient way to protect yourself.
Restrictions on short-selling can occur when a regulatory body halts the ability to practice this technique on a given stock. This is done due to economic reasons and it aims at protecting companies and preventing abuse.
If too many speculators short a stock at the same time, the stock price may collapse. The snowball effect can affect the valuation of a company and it creates a negative situation for an otherwise economically viable company.
Therefore, in order to reduce the risk that short-selling poses on businesses, financial market authorities have adopted strict rules. One of these rules requires the latter to own a percentage of the loaned securities. Another rule is the obligation to publish short-selling positions, and once a certain limit has been reached, the positions are made public.
What Was The GME Hype About?
Let’s examine a real-life example of a short-selling snowball effect. You’ve probably heard by now that retail investors, led by the WallStreetBets Reddit chatroom, managed to use one of hedge funds’ common investment strategies against them. They aggressively piled into Gamestop, AMC Entertainment, and other stocks. The buying pushed the prices upwards against the funds’ bets expectations and they lost huge sums of money. To date, the Gamestop short-sellers losses amount to at least $5 billion. This group demonstrated how retail investors can hit hedge funds, and the battle brought to light the great risks of heavy short-selling.
The health of the market may require the occurrence of short-selling. That’s because it contributes to the regulation and balance of stock markets. Moreover, short-selling brings liquidity to financial markets and helps in fraud detection. The conventional method of short-selling stocks is to borrow the stock, and then sell it on the open market. Then buying it back when the prices fall. But new techniques allow traders to speculate on prices without ownership. Those who favor short-selling claim that long periods of uninterrupted rise lead to imbalance and overvalued assets. That’s where the role of short-selling as a regulation mechanism comes into play. Making the case, even more, is that historically, trading short has proven to be the best way to attract liquidity to a market. However one must not ignore the significant risks involved in this trading practice, and it is only to be applied with wisdom.
Want to Trade Forex?
OspreyFX is the perfect partner to help you on your trading journey. We pride ourselves on offering our traders the right tools needed to ace the markets, traders can now trade with better insight with our Forex Calculators.