The Theory of Short-Selling

Selling stocks short can be a lucrative, albeit risky, way to invest if you’ve ever wanted to benefit from a company’s misfortune. Sometimes investors will become persuaded that a stock’s value is more likely to fall than to rise. If this is the case, investors can potentially profit when the value of a stock falls by employing a strategy known as “Short Selling.”

Short selling, also known as shorting a stock, is intended to profit you if the share price of the stock you want shortfalls, but it may also cost you money if the stock price rises.

Let’s take a closer look at the concept of short selling. And then we can use these techniques to strengthen our trading strategies.

What Is Short Selling?

Short selling is an investment or trading strategy that bets on the decline in the price of a financial asset. It is a sophisticated tactic that can only be attempted by seasoned traders and investors.

Short selling can be used as a form of speculation by traders, and it can also be used as a hedge against the downside risk of a long position in the same or similar security by investors or portfolio managers.

Why you should short a financial asset?

Typically, you can plan to short a financial asset if you believe it is overpriced or will decline for some reason. Since shorting includes borrowing and selling shares of financial assets that you do not own, a drop in the share price allows you to buy back the shares with less money than you got when you sold them.

Nevertheless, there are some other circumstances in which shorting a financial asset can be advantageous. If you own a financial asset in a specific industry but want to protect against an industrywide risk, shorting a competing financial asset in the same industry could help. Shorting a financial asset can also be a better tax strategy than selling your own holdings, particularly if you expect a short-term decline in the share price that will most likely reverse itself.

What is the step-by-step process of implementing the Short-Selling Strategy?

  • Determine which stock you want to sell short.
  • Confirm that you have a margin account with your broker and that you have the requisite permits to open a short position in a stock.
  • Submit your short order for the desired number of shares. When you submit the order, the broker will lend you the shares and sell them on your behalf on the open market.
  • At some stage, you’ll need to close out your short position by repurchasing the stock you originally sold and then return the borrowed shares to the person who lent them to you from your brokerage firm.
  • If the price drops, you’ll pay less to replace the shares and keep the difference as profit. If the stock price rises, it will cost you more to buy back the shares, and you will have to find the extra capital elsewhere, resulting in a loss on your short position.

Risks involved in Short-Selling

The most significant risk of short selling is that if the stock price increases sharply, you can have trouble covering your losses. In theory, shorting can result in infinite losses; after all, there is no upper limit on how high a stock’s price can rise. Your broker would not require you to have an infinite supply of cash to cover potential losses, but if you lose too much money, your broker can issue a margin call, forcing you to close your short position by buying back the shares at the worst possible moment.

In contrast, short-sellers are often forced to close their positions abruptly due to unforeseen circumstances. When a stock is a common target for short-sellers, it can be difficult to find shares to borrow. If the shareholder who lent the stock to the short seller wants those shares back, you’ll have to cover the short the broker will compel you to repurchase the shares sooner than you’d like.

Suitable Situations to use Short- Selling

In the midst of a Bear Market: During a bear market, the prevailing trend for a stock market or business is downward. Traders who agree that “the trend is your friend” have a greater chance of making successful short-selling trades during a deep bear market than they do during a solid bull market. Short sellers thrive in conditions where the market downturn is rapid, long, and intense, such as the global bear market of 2008-09, because they stand to benefit well from it.

Whenever the fundamentals of a stock or market are decaying: The fundamentals of stock can deteriorate for a variety of reasons, including slowing sales or profit growth, increased market difficulties, growing input costs that place pressure on margins, and so on. Worsening fundamentals may imply a string of weaker data points indicating a potential economic downturn, negative geopolitical developments such as the threat of war, or bearish technical signals such as new lows on declining volume and weakening market breadth.

Skilled short-sellers may tend to wait until the bearish trend is confirmed before entering into short trades, rather than entering into short trades in expectation of a downward step. This is due to the possibility that a stock or index will trend higher for weeks or months despite weakening fundamentals, as is common in the final phases of a bull market.

Disclaimer: There are potential risks relating to trading and investing and you should not trade with money that you cannot afford to lose however, for those that educate themselves and adopt appropriate risk management strategies, the potential update can be significant. Please note that all opinions, research, analysis, and other information are provided as general market commentary and not as specific investment advice.

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