Short Selling in a Nutshell
*OspreyFX would like to state that traders should research extensively before following any information given hereby. Any assumptions made in this article are provided solely for entertainment purposes and not for traders to guide or alter their positions. Please read our Terms & Conditions and Risk Disclosure for more information.
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 quarter earnings miss.
Markets to trade a short position on
- Commodity CFDs
- Index CFDs
- Bond CFDs
- Share CFDs
- Foreign Exchange
Popular stocks for short-selling
- Deutsche Bank
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.
Short-selling with CFDs
A Contract for Difference (CFD) allows traders to speculate on prices without ownership of an asset. It is mainly a contract between two parties: the trader and the broker. At term, the parties examine the difference between the price of the stock at the time they entered into a contract and the price at the end of it. The trader will pay the difference between the opening and closing price. The concept is simple and that’s why short-selling stock CFDs is very popular. Some of the benefits of this strategy include:
- Leveraging trade positions higher than their balance.
- Long or short directions on trades without extra charges on short sales.
- Using advanced risk management tools.
- Accessing global stock markets.
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 to 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 is the GME Hype About?
Let’s examine a real-life example of a short-selling snowball effect. You’ve probably heard by now that recently 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 is demonstrating how retail investors can hit hedge funds, and the battle is bringing 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 such as Share CFDs allow traders to speculate on prices without ownership. Those who favor short-selling claim that long periods of uninterrupted rise leads 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.