Short-selling or shorting is a risky trading strategy. It requires careful planning and execution to make it work.
That’s why it is recommended for experienced traders only and experts do not suggest it for novice traders.
Let us discuss what is the short-selling mechanism, its risks, and its rewards.
Short Selling – Mechanism
Short selling is a trading style where traders look to make profits with declining stock prices. Shorting can be used for speculation or hedging.
Short selling requires borrowing stocks from a broker, immediately selling them at the market price, and buying them back when stock prices fall.
It means traders benefit when stocks lose value contrary to the common practice where traders make money when stocks appreciate.
Shorting also requires using a margin account and the use of the leverage offered by brokers is a key concept in this strategy.
Short-selling is an advanced trading strategy and is more suitable for experienced traders. It comes with many benefits but some extravagant risks as well.
Is Short Selling a Good Strategy?
Like any other trading strategy, if it is executed well, it can be a good strategy to make money. In particular, it can be used when the market trends are bearish to make profits.
Some experts argue that short-selling is unethical. However, it helps investors and the market collectively in a few ways that wouldn’t be possible otherwise.
For example, speculators bring out facts about a particular stock to elaborate on why they are performing poorly. It would help shareholders and the company to ratify and amend its policies in the long run.
Similarly, short-sellers would highlight the market inefficiencies through which they can exploit the overvalued stocks.
For investing purposes, short-selling is highly risky but it can be fruitful for many traders if they do it correctly.
Why Do Investors Short-Sell?
Short-selling is adopted by corporate and retail investors alike. Most traders look for profits through speculations when shorting stocks.
Traders can identify overvalued stocks due to market inefficiency or some other factors. They may require strong technical indicators to back their claims though.
Most corporate investors like hedge funds and insurance funds look to hedge their investments with short-selling.
Shorting can be arranged to minimize different types of downside investment risks like hedging call options.
Risks of Short-Selling
One of the major concerns about short-selling is its perceived risky nature. It is a highly risky investment strategy where the maximum losses on your investment can be unlimited.
Here are a few key risks associated with shorting.
Market Risk
Unlike the expectations of traders, the market may move upwards generally. It may be due to macroeconomic factors such as a change in the interest rate or due to specific reasons in the economy.
Such situations would trigger short-sell covers that may further increase your trading costs.
Appreciation Trend
Short traders would benefit when their invested stocks fall. It means they’ll only make money when the stock loses value.
However, it may not be the case and the stock may start an appreciation trend. It may be due to good performance news, market demand, or any other trigger.
Margin Call and Interest Costs
You’ll have to open a margin account to place the short trade orders. Brokers require minimum margin levels for placing trade orders.
If the stocks appreciate, you may receive a margin call and would need to deposit more funds in the account.
It would also mean you’ll have to wait longer incurring higher interest costs as well.
Short Squeeze
When trends move unfavorably to short traders, they start covering their trades. It means they would need to buy stocks to repay them to the brokers.
In such situations, stocks become “hard to buy” and brokers charge a premium on top of the regular prices.
Regulatory Risks
Regulators impose restrictions on short trades in many jurisdictions. For instance, regulators restrict short-selling stock in a single day if it falls more than 10% in price.
In some cases, regulators may put a complete ban on shorting for a specific period or in a specific area.
Such changes in laws can hamper your trading strategies at any time.
Loss of Dividends
There is no dividend income for traders when they hold stocks for shorting. It is because they hold borrowed stocks and not purchased ones.
So, if the company announces dividends, your broker will deduct that amount from your brokerage account.
Macroeconomic Events
Some macroeconomic events can work against your strategy. For instance, if there is a change in the interest rates, the market may react positively.
It may trigger a bullish stock market trend which would go opposite to what short traders would want.
Rewards of Short-Selling
The risks of short-selling are high but the rewards are also attractive. It comes with a risk of unlimited losses but can offer some great advantages as well.
Minimum Investment
Traders use margin accounts for shorting the stocks. These accounts use the leverage offered by brokers.
Thus, you require a lower investment when devising a short-selling strategy. However, your margin requirements may change with a change in the stock price.
Nonetheless, the use of leverage is a great benefit for traders looking to make quick profits.
Profit When Stocks Fall
Unlike common practice, investors can make profits when stocks fall. Despite some arguments against the ethical values of shorting, it brings profits when stocks lose value. Without short-selling, making profits from a falling stock would have been impossible.
Profits in Bearish Markets
Bearish stock market trends may continue for any length. If no short-selling existed, many traders would not be able to make profits.
Shorting allows traders to earn money even in the bearish markets when most of the stocks are falling regularly.
Hedging
Shorting is not only for speculators. Hedging with short-selling is also a useful investing strategy.
Retail and corporate investors looking to make money with different trading styles can use shorting to hedge their positions.
For instance, shorting a stock when you have invested in call options is a good hedge. It can be used to minimize your downside risks.
When Does it Make Sense to Short-Sell?
Short-selling is not a common trading strategy. Most investors look for long-term gains and expect stock prices to move up generally.
Short-selling makes sense when there is an established bearish stock market trend. During a bearish trend, stocks would generally fall.
However, the risk in this situation is that your chosen stock may become “hard to find” as brokers wouldn’t be willing to sell these stocks immediately at lower prices.
In other situations, if a company is facing financial difficulties or going through a radical change, it would trigger a stock price fall for a while.
Either way, you’ll need to conduct extensive market and stock research before betting through shorting.
Tips to Make Profit with Short-Selling
Shorting is not an easy strategy and it shouldn’t be practiced unless you gain experience. Here are a few tips for you to make it work.
Choose Your Timing
Timing the short trades is crucial. You’ll need to plan and execute your short trades quickly and within a specific time.
Also, if you prolong your short trades, your interest costs will increase as you would be using borrowed money through a margin account.
Research the Market
Before you devise a short trade, conduct thorough market research. Unless your chosen stock has specific reasons, it is unlikely that the stock prices would fall.
In other words, you’ll have to find the overvalued stocks before the market realizes it.
Use Stop-Loss Orders
You should always set your stop-loss and trailing stop-loss orders for any type of trading strategy. The same holds for a short trade as well.
Unless you set a stop-loss order, your loss can be unlimited theoretically as the stock price may increase indefinitely.
Minimize the Use of Leverage
When traders use leverage, they pay interest over it. If the leveraged funds are held for a long time, it may reduce your profits.
For instance, if the broker charges you 5% interest cost and you held the position for 6 months, you’ll lose 2.5% of the total investment just because of the interest cost.
So, if you can use your own funds, you can minimize the interest costs.
Avoid Strong Stocks
Short-selling doesn’t work when stock prices appreciate. It means you should avoid strong and established stocks that tend to move upwards generally.
Again, doing extensive market and stock research can help you maximize the benefits of short-selling.
