What Is Short Selling And How Does It Work?

Although trading is usually associated with buying assets and profiting from their price increase, there is another possible scenario. Short selling is an opposite practice that allows traders to speculate on the asset price decrease. Unlike long position trading, it is riskier and requires more knowledge, skills, and experience.
In this article, we have gathered all the information about short selling, its key features, pros and cons to help you mitigate the risks and take advantage of the positions in the falling market as well.

What Is Short Selling?

Short selling is usually a short-term trading strategy that allows investors to speculate on the falling asset value. A trader borrows some stocks or other securities from the brokerage firm and sells them directly with the expectation that their price will continue to drop in the near future.
If his predictions are correct, he repurchases them and returns to the broker, reaping the profit from the difference between the selling and the buying price. In case the market turns against the trader and the asset price goes up, he will have to deposit more money into his account or close the trade at an unfavorable for him price, thus, incurring a loss.
Although the strategy of short selling seems quite simple at first glance, it comes with some pitfalls and risks that need to be taken into account.

How Short Selling Works - Example

Win case

Let’s assume that an investor considers that the Facebook (Meta) FB stock price (currently traded at $230 per share) will be going down this month. Therefore, he decides to go short, borrows 50 stocks from his broker, and sells them for $11500. A week later Facebook (Meta) publishes an unfavorable quarterly report that makes its stock price drop to $210 per share. The trader closes his short position by buying 50 Facebook stocks ($210*50=$10500) and returning them to the broker. His profit in this situation will account for $11500-$10500=$1000 (minus interest and commissions).

Loss case

Following the above-mentioned example, the trader has a short position of 50 FB shares (sold for 50*$230=$11500), whose price was declining. However, the company releases the data about robust revenue growth, which causes its stock price to soar to $250 per share. The investor decides to close the trade at this price. In this situation, he faces the loss of 11500-(50*$250)= -$1000 (plus interest and commissions).

What Is the Purpose of Short Selling?

There are two main reasons why investors resort to shorting: they either speculate or hedge. Let’s dive into each of these purposes.

1. Speculating means taking advantage of asset price fluctuations. Speculators are on the lookout for overvalued assets to gain profits when their value decreases. It’s worth noting that short speculating is significantly riskier than long trading. If the market moves in the opposite from the predicted direction, the asset price may continue growing, leading to dramatic losses.
2. Hedging, in contrast to speculating, is not about making profits but about protecting long trades from potential losses. For example, an investor has a buying position of Facebook (Meta) shares and wants to keep them for a long time. However, he expects that FB stock price will decline in a short distance. To mitigate risks, he opens a short position for this asset. This way, if the stock price drops, the investor will offset the losses in his main portfolio by profiting in shorting. In case the FB price goes up against his expectations, he will lose on the short trade while profiting from the long position.

Advantages of Short Selling

Although short selling carries significant risks and is quite complicated for inexperienced traders, it offers some advantages as well.

1. Leverage. When going short, it’s possible to apply leverage. It means that to enter a trade investors don’t need to deposit the full value of the position, they have to put in only the initial margin.
2. Bigger exposure. Short selling allows speculators to take advantage of both bull and bear markets, increasing their profit potential.
3. Hedging. Shorting is an efficient risk management tool. If investors didn’t manage to get rid of falling assets in advance, they can open short positions, offsetting their losses in the main portfolio.

Risks of Short Selling

Short selling can be an advantageous trading strategy, however, it requires much experience and skills to mitigate its numerous risks. Here are the most important of them.

1. Potentially unlimited losses. In contrast to long trading where speculators can’t lose more than they invested, shorting doesn’t have this limit. In case, trader expectations are wrong, and the price boosts instead of dropping, his loss will continue rising with the asset price. However, some trading platforms allow their clients to use the Negative Balance Protection rule, which guarantees the limit on retail client losses.
2. Extra expenses. Short selling requires a margin account. To open one, investors have to deposit the initial margin. Moreover, they have to continuously keep control over the maintenance and add required capital to avoid margin calls. Being based on borrowing, going short also implies the interest charges that should be paid regularly while the position stays open. Last but not least, short positions may imply some extra commission and fees according to the broker policy.
3. Margin calls. If the total value of the investor margin account falls below the maintenance requirement, they will have to respond to the margin call, adding cash or other collateral to reach the required percentage. In case traders don’t react immediately, brokers have all rights to liquidate their other assets to cover the debt.
4. Short squeeze. It’s a situation when many investors opened short positions, expecting that the asset price will decline, however, it continues growing instead. As a result, to limit their losses traders start to actively purchase their assets back, this way, creating the demand and pushing the price to go even higher.

How to Short Sell

If you decide to diversify your portfolio by going short, here are the steps to follow.

1. Open a margin account. Since shorting always comes with the borrowing procedure, before implementing it investors (also called short-sellers) need to make sure they have a margin account.
2. Comply with initial margin requirement. Traders have to deposit a certain amount of cash or collateral (usually kept up to 50% from the position total value) to open the short trade.
3. Meet the maintenance margin requirement. Maintenance is the minimum amount of cash or collateral that a trader should keep in his account after opening the position. This percentage may vary, yet is usually kept between 25% - 35%. If the trader fails to meet this requirement he will receive a margin call asking him to add necessary funds.
4. Pay the margin interest while holding the position. Speculators can keep the short trade open as long as they want. However, it’s important to remember that the interest will accrue throughout this period. When it comes to its amount, the interest rate depends on the broker and is usually calculated based on the total loan size.
5. Close the trade. To close the short position an investor should execute the opposite trade. For example, if the stock price drops according to the trader’s expectations, he can buy back his assets and return them to the brokerage firm. The profit will be equal to the difference between the selling and the buying price, excluding the interest charges and possible fees.

Short Selling Strategies

Once decided to short sell, it’s important to develop an efficient trading strategy. Here are some common techniques to consider.

Selling Pullback In a Downtrend

A pullback trading strategy is based on following the market trend, where a pullback represents the price movement against it. Since the market is constantly floating, the pullback technique can help investors take advantage of more prompt market moves and gain higher potential returns. The main idea and advantage behind this approach are that traders buy assets at a low price and sell them at a higher value. Moreover, being a trend-following technique, it makes speculators feel more psychologically confident, preventing them from poorly-considered decisions.

Choose The Right Timing

Timing plays a huge role in either long or short selling. First of all, to identify overpriced assets to open short trade, it’s necessary to continuously conduct market research and stay informed about recent industry news. Moreover, it’s crucial to remember about holidays since the price fluctuations don’t follow the common rules during these periods. When it comes to how long to hold the short position, there is no universal solution. Every trader decides it for himself based on the timing expectations and risk management strategy.

Short Sell On Bear Markets

Theoretically, all assets show the uptrend in the long term, which makes bear markets not so common. Thus, some traders are in a rush to open short trades on bear markets. This usually leads to dramatic consequences and serious losses since it can be compared to fighting with the windmills.

Day Trading

Day trading is a popular strategy among short-sellers that suggests the trade is opened and closed within one day. The main idea behind this technique is to take advantage of market volatility and profit from slight asset price moves.

Set Stop-Loss Orders

Stop-loss order is an efficient tool in mitigating trading risks. As well as in long trading, short-sellers implement it to protect themselves from sharp market moves (in case of shorting, from the price rise). Investors set a buy-stop-loss order that automatically closes the trade if the asset price reaches the limit. For example, if an investor has a short position of 50 shares of a fictional company “AAA” currently traded at $100 per stock, he can place a buy-stop-loss order at $110. This way, if the stock price grows, the trader’s position will be closed when reaching $110, preventing possible substantial losses.

Use Short Selling Metrics

Short selling metrics are instruments that help investors analyze the market and identify the common sentiment - either buying or selling. The most common of them are the Short Interest Ratio (SIR) and the Days to Cover Ratio.

• The short interest ratio is a measurement that is calculated by dividing the number of shorted shares by the stock’s average daily trading volume.

• The days to cover ratio represents the time frame necessary to buy back outstanding entity shares that are on the short trade. It is calculated by dividing the short interest by the average daily trading volume. As well as SIR, this ratio can help investors understand when it’s better to open or close short positions, moreover, providing them with some signs of the short squeeze possibility.

Use Technical Indicators To Confirm the Downtrend

Technical indicators are calculations based on the price, volume, and other characteristics of the security used by traders who implement the technical analysis. Their main goal is to help investors make sure they face a bearish trend and define their entry and exit point to receive higher potential returns and mitigate risks.
There is a huge variety of indicators, such as moving averages, MACD, and others. To decide, which tool to use, investors have to try out different of them and understand which complies best with their trading behavior and strategy.

Knowledge Is Power

Any type of trading comes with a certain risk. Continuous learning may be one of the efficient ways to mitigate them. Keep up with the market news, educate yourself about innovative instruments and strategies, analyze the behavior of more experienced traders. This will help you gain extra experience, avoiding newbies’ mistakes.

What To Consider When Short Selling

Short selling is a very controversial strategy that faces much criticism. Apart from the main risks mentioned before, it may be accompanied by some other pitfalls. Let’s have a closer look at them.

Shorting Uses Borrowed Money

Since short selling implies borrowing, it is related to margin trading. This is a two-edged sword. On the one hand, margin allows speculators to open leveraged trades. However, on the other hand, it makes them comply with certain conditions (such as initial and maintenance margin requirements), which can require much capital.

Additional Regulations

There is a possibility that regulatory bodies may introduce some shorting restrictions that will spur investors to buy their assets back. This can result in a sudden demand and consequent price rise, meaning that short-sellers could suffer from unexpected and tremendous losses.

Betting Against the Trend

In theory, all assets show growth in the long perspective. Playing on the opposite trend, short-sellers are always in a weak position, thus, have to tolerate a much higher level of risk.

Wrong Timing

As mentioned above, timing plays a crucial role in the results of the trade. Although everything may indicate that the company is overpriced and its asset value is going to drop, it may not happen immediately. Thus, not to be trapped in a losing trade, investors should be aware of this possibility and be prepared for it.

Costs of Short Selling

Once you decided to go short, it’s crucial to make sure you are aware of all the possible costs that may occur in the process. Let’s sum them up.

Margin Interest

Margin interest can be a reason for significant expenses. Although it’s usually not a huge percentage (calculated on the base of the borrowed amount, time frames, etc.), this rate is accrued daily and can result in large sums if the trade is opened for a long time. This is the reason why shorting is mostly about short-term trades.

Stock Borrowing Costs

If a trader wants to borrow stock from a “hard-to-borrow” list, meaning that it is running out or prone to volatility, he will have to pay some additional fees. The amount of them may vary from a small percentage to huge sums, exceeding the total value of the short trade. This is caused by the fact that such fees accrue throughout the period that a trade stays open (as well as the interest). What’s more, it’s challenging to predict these expenses in advance, as their amount is not fixed and fluctuates with the market.

Dividends And Other Payments

Apart from interest, fees, commissions, and margin account requirements, traders are obliged to pay dividends to the party who technically owns the assets. For example, let’s take a fictional company “ABC” which pays its stockholders 50 cents quarterly dividends. In case, the trader has a short-selling position of 1000 ABC stocks and he keeps it open passing the next ex-dividend date, he will have to pay off his broker $500 for dividends.
Other payments that short-seller should be ready for can be caused by some unpredicted market events, such as extra share issuing.

Conclusion

Many traders find it quite complicated to achieve consistent profits with a short-selling strategy. And they have a reason to say so. Going short comes with many significant drawbacks. It’s much riskier than going long, it requires more capital outlay, investors have to fully devote their attention to such positions not to face a margin call and related potential losses. However, with sufficient experience and skills, short-selling can be advantageous as well, providing traders with potentially higher returns.
The choice, whether to take the risk of shorting or not, is up to you. Yet, once you opt for it, it’s crucial to understand all the features of this trading approach, keep educating yourself, develop an efficient risk management plan, and strictly stick to it.