Short selling is a trading strategy that speculates on reducing the value of assets, securities or cryptocurrencies. It’s quite dangerous, so only experienced traders can successfully use it.
“Shorts” can be used both for speculation, in order to maximize profits, and for hedging, for reducing the risk of decreasing a long position. And if the first option significantly increases the chance to spend your own money, then the second - on the contrary, reduce possible losses by creating a compensating position.
How it works?
Here is the point. A short position is always selling an asset that the trader does not have. This asset is borrowed from a broker with the expectation that in the future its price will decrease markedly. The trader is selling the resource right now at a bargain price, waiting for its further decline, then - acquiring the same amount of the asset at a reduced price and returning it to the broker. The difference in cost minus technical costs is profit.
The problem is that price can behave differently - start to rise. And for the use of “borrowed assets” you have to pay, moreover, for interest rate which increases every day. Or, if marginal trading methods are used, then more. Therefore, the risk here is very great. But the benefit, if it used correctly, is significant.
But what prevents a trader from taking an asset on credit, selling profitably, and then simply dissolve with profit without even thinking of closing an open position? Existence of regulators such as the Financial Industry Regulatory Authority, Inc. And the presence of a huge number of rules regarding “shorts”. At a minimum - the need for a special margin account with a certain amount on it. This amount must exceed a certain sum, known as the “service margin,” which is calculated based on the value of assets taken on credit. If the amount of money in the account is less than this value, the account will be blocked.
As already mentioned, the trader’s profit when working with short positions is the difference in cost between selling a loan product now and buying it at a reduced price in the future. Plus expenses, since brokers set interest for the use of their services on their own, and exchanges charge fees for trading. At the same time, all brokers also act within the framework of the rules and must receive appropriate qualifications before they allowed to margin trading.
Short selling and hedging
In contrast to making net profit when using “shorts” for speculation, hedging has a slightly different goal - the overall reduction of risks and associated losses. However, in normal situations, most traders do not consider this option, since it not only reduces risks, but also reduces potential profits. Simply put, if 50 percent of the entire stock portfolio is hedged, then the possible profit and possible losses are cut in 2 times.
We will consider this tactic in more detail in the corresponding article.
Pros and cons
Short selling has both pros and significant cons.
- Ultra-high profit in a short time
- Small initial investment (due to margin trading and “leverage”)
- The ability to use borrowed resources
- Effective hedging
- Potentially unlimited losses (if the price of assets does not fall, but grows, and the time for closing a loan obligation is running out, you have to buy assets at any price)
- The need for a margin account. And the presence on it of certain, rather large amounts. Which can be lost if the strategy turns out to be wrong.
- The need to pay marginal interest. It doesn’t matter what you take on credit - money or resources - each extra day of owning them costs a certain amount.
- The situation of "short compression" (more on that later)
The main advantage of short positions is the ability to use margin trading. This means that the trader is not required to fully cover the value of the assets with which he is going to work. The exchange provides him with a “leverage,” which can be very profitably realized if the dynamics of price fluctuations are correctly calculated.
Additional risks of shorts
In addition to the main risk - incorrect prediction of the dynamics of changes in asset prices, there are other potentially dangerous situations in work with shorts.
- The using of borrowed funds. Short sales are not possible without the mediation of brokers and the use of margin accounts. And if you use these funds for a long enough time, the percentage that has accrued may exceed the “maintenance” limit of 25 percent of the total bill value. And in this situation, either you have to add your own funds, or - lose the whole account in favor of the broker and the exchange. This situation is called “marginal recall.”
- Incorrect timing calculation. Yes, the price may fall, but not as fast as the trader would like. And all this time the margin will increase.
- Short Squeeze. Here is the point. If the price of assets suddenly starts to rise, the fastest traders can start to buy their own short positions in order to protect themselves from losses. This causes a surge of excitement about this asset and further price increasing. Which makes even more traders close their positions. As a result, the price of an asset increases dramatically, those who played on the increasing - receive super-profits, and enthusiasts of short sales - manage to slightly reduce losses, in the best case.
- Regulatory risks. Regulators can temporarily block, and sometimes completely cancel, the ability to use short positions in certain categories of assets. This is necessary to avoid panic in the market and deliberately create pressure from some sellers. However, regulators very rarely warn in advance about their plans, so short sellers often find themselves in a situation where they need to close their positions somehow right now. At any price. This entails huge losses.
- The movement against the trend. In the long run, the vast majority of assets increase in value. Slowly but surely. And not even due to the progress of the company, but simply because of inflation. So “shorts” work against the general direction of the market, which means that you need to constantly “catch the moment”.
Short selling expenses
If you just buy and sell shares, you only have to pay a transaction fee and storage costs. With short positions, everything is somewhat more complicated.
- Margin Interest. They tend to accumulate over time, especially if a short position is open for a long time. Exposed by the broker for personal reasons, so they can be quite high by default.
- Share borrowing price. It is not free, yes. The cost can range from a few fractions of a percent to more than 100 percent of the price of an asset. Usually, this price is directly related to the annual rate. And what is most unpleasant - it can actively fluctuate even during one working day. So an unpleasant surprise can happen when at the end of the month the broker deducts the currency equivalent of the price of borrowing shares from the client’s account. This amount cannot always be predicted.
- Dividends and other payments. Short sellers are considered holders of stocks and assets until they close their position. So it is they who have to pay dividends, participate in the distribution of shares and spin-offs on them. These events are unpredictable, but you need to be prepared for them.
Short Sales Indices
Basically, two metrics are used that allow us to measure activity in this financial sector:
- Short interest ratio (SIR). Shows the ratio of assets in short positions to the total number of available assets. A high index can mean either an active fall in prices or overestimated market expectations.
- “The short interest to volume ratio” or “the days to cover ratio”. The ratio of the total number of assets held uncovered to the average daily trading volume of these assets. A high value indicates a bearish trend.
Optimal conditions for short sales
In this case, the main thing is to guess the moment. The fall in the value of assets, usually, is more rapid than the rise in prices - we are talking about days and weeks. But if you make a deal too late, in the hope of an even greater fall, there will be too much "lost profit." And if it is too early, then the associated costs will increase significantly, which will seriously reduce the possible profit. Again, you also need to choose the right moment to close the short position.
But there are some predictable situations, where the possibility of successful short trading increases.
- Bear market. When there is a stable downward trend, you can not be particularly afraid of sudden fluctuations. And act calmly "like everyone else."
- Deterioration of fundamental market indicators. That means - a decrease in total profit, an increase in the cost of entering the market, an increase in margin, a greater number of asset calls. All this indicates a general deterioration in economic indicators and a natural decline in the value of almost all assets.
- Technical indicators confirming the bearish trend. Some indicators with a high degree of probability indicate a further persistent fall in prices. An example is the "Cross of Death" - the fall of the 50-day average moving price line below the 200-day moving average line.
- Overvaluation in the phase of "Unbridled optimism." The natural reaction of investors whose expectations were not fulfilled is to sell. Behind this “disappointment” there is always a downtrend that can be used for effective short sales.
In 2008, investors became aware of the potential merger of Porsche and Volkswagen. This naturally should have led to liquefaction of Volkswagen stock prices, so many short sellers began to quickly open short positions, hoping to play this decline in the future.
However, it turned out that almost the main buyer of these shares at still normal prices were Porsche representatives. They managed to buy up almost 70 percent of all possible shares. Another 20 percent belonged to the government and did not go into business. And short positions had to be closed somehow. A situation of short contraction formed, as a result of which the stock price jumped from 200 euros to 1000, and many short sellers went bankrupt because they could not close their positions on time. A month later, however, the price returned to normal.
As you can see, short positions are extremely effective, but also an extremely dangerous investment mechanism. Beginners are better off not taking risks during work with them. There are much more effective, reliable and predictable strategies of behaviour. However, if you really understand the situation, then effective speculation can bring you real superprofits.
Short Sales Reputation
On the one hand, this is an extremely simple way to “drown” the shares of almost any company. On the other, an effective method of preventing hype and excessive optimism about unstable and unpredictable stocks, cryptocurrencies and resources. This is perhaps one of the few really effective mechanisms for controlling “asset bubbles” in the early stages.
In addition, the use of short sales is impossible without a comprehensive analysis of the market and the dependence of price formation on external factors and moods. So short sellers are the very first to identify negative trends and respond more quickly to unexpected news.
However, this strategy also has negative aspects. In the best case, ruthless speculation, in the worst, organized “bear raids” in order to minimize the price of vulnerable assets. And although this is officially illegal, such situations happen regularly.