Short Selling – How to take advantage of falling market prices by shorting stocks

While shorting stocks you can generate returns during corrections or a market crash

Short Selling Stocks
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Short selling is often portrayed as somewhat mysterious and even as controversial. Actually, short selling is an important tool for traders and investors alike. Short selling stocks allows traders to profit from falling prices and hedge the market risk of a portfolio. Even long term, long only investors should understand the effects shorting can have on prices. If you would like to know how to short a stock, or if you would like short selling explained step by step, along with the reasons for short selling and the mechanics involved, read on.

What is short selling?

Short Selling
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Short selling an asset entails selling an asset you do not own. Short selling stocks allows traders to profit from falling prices, which can be done for several reasons. In order to sell an asset, you do not own, you first must borrow it from someone that does own it. The result is a short position because you owe the asset to whoever you borrowed it from. Shorting a stock differs from merely selling the stock when a long position is held.

If you sell when you have a long position, your position goes from long to flat. When you sell a stock with no position, you are going from flat, to short. Naked short selling occurs when you sell a security you do not own without first borrowing the security. In some markets this is logistically impossible, or even illegal – while in others it is not. In fact, short selling itself is illegal in certain countries.

Why do investors and traders short-sell stocks?

Trader Buy / Sell
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There are three primary reasons for shorting the market or an individual security. Firstly, it allows one to profit from an anticipated decline in the price of a security or the market as a whole. Secondly it allows one to hedge the risk of a broad market decline. By selling certain securities while simultaneously holding a portfolio of assets, the portfolio’s market risk, or systematic risk, can be removed. The portfolio will still benefit from stock specific growth but won’t be affected by negative price movements that affect the entire market.

And finally, it allows one to profit from the relative performance of one asset over another. If a trader believes stock A will outperform stock B, they can open a long position in stock A and a short position in stock B. The combined positions will be profitable provided that stock A outperforms stock B. This can even occur when both stock prices decline. Short selling stocks can be used for investment portfolios targeting absolute rather than relative returns.

In other words, a portfolio seeking to make positive returns rather than outperforming a benchmark would use short selling extensively. Traders and hedge funds can also profit during a stock market crash by short selling stocks. This enables long/short funds to profit during bull and bear markets. In addition, portfolio volatility can be reduced by shorting to hedge positions. Black swan events cannot be predicted but holding short positions in a portfolio can reduce the damage they can do to the portfolio.

Catana Capital’s Data Intelligence Fund uses big data analysis and artificial intelligence to identify opportunities to open positions in european stocks. The algorithms source user generated data that can be used to create market sentiment scores. By combining these scores with traditional data sources and price data, timely trading signals can be generated to open long and short positions in the DAX future for exposure management with positive expectancy.

How to short stocks

How to Short Stocks / Short Selling
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Modern technology and new trading instruments have made the process of shorting a stock a lot easier than it used to be. For institutions wanting to open large short positions the process can still be quite complex. Once a decision has been made to short a stock, the first step is to find stocks to borrow. There are several platforms and brokers that act as intermediaries to secure stocks to borrow. Borrowers must pay a stock lending fee and institutions lend stocks to increase the yield on their holdings.

Stock lending rates work just like interest rates. Stock is lent at an annual rate, and the borrower pays a pro rata rate based on the number of days they borrow the stock for. Rates are generally close to 1% per annum but can increase to over 20% for stocks that are in short supply. Once the stock has been secured and a lending rate negotiated, it is delivered to the borrower under the terms of a contract. That stock can then be sold at the prevailing market price and delivered to whoever buys it.

The fund short selling the stock receives payment for the stock based on the price it was sold. They now have a long cash position but are short of the stock which they still owe to the lender. A short position is closed by buying back the shares and then returning them to the lender. The profit or loss on a short sale is equal to the amount received when the stock was sold minus the amount paid to buy it back and the amount paid to borrow the stock.

Shorting using derivatives

Shorting using Derivatives / Short Selling
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The process of short selling stocks may seem very complicated, but these days most of it is automated. Retail trading platforms allow traders to short sell stocks on an approved list without even being aware of the process taking place in the background. So far, we have looked at the most direct way of shorting a stock. Similar results can be achieved in other ways too. A derivative instrument like a futures contract or CFD (contracts for difference) on the same stock can be sold without the trader having to borrow the stock.

Futures contracts are created when a buyer and seller agree to a trade, without the need for anything to be delivered. However, in the case of contracts that are physically settled, the seller will have to deliver the underlying asset when the contract expires. The reality is that most contracts will be closed before expiry, eliminating the need to deliver or borrow securities. Futures contracts that are cash settled can even be held until expiry without the need to sever deliver the underlying assets.

Put options give the holder the right, but not the obligation to sell a security at a specific price if the share price is below that price at expiry. This creates an effective short position without the need to borrow or short sell stock. However, if the option seller wants to hedge their position, they will need to short sell the underlying asset.

What is a short squeeze?

Short Squeeze
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One of the well-known characteristics of bear markets is very sudden, extended rallies, known as bear market rallies. These rallies are often steeper and longer than the typical rallies that take place during a bull market. Bear market rallies are often the result of a short squeeze. A squeeze occurs when a rally forces shorts out of their positions. This can in fact happen during bull and bear markets but is more common during bear markets.

There are several reasons that short squeezes occur. Firstly, potential losses are unlimited for short positions. If you buy a stock for $10, the most you can lose is $10. On the other hand, the potential loss from shorting a stock at $10 is unlimited as the stock price could rise to $20, $1,000 or more. Secondly, in general stock prices have an upward drift due to inflation and economic growth. There’s a good chance that a stock that falls from $10 to $5 will eventually get back to $10. But a stock that rises from $10 to $20 may never get back to $10. Shorting a stock and then holding onto it as it rises means you have limited upside and unlimited downside.

Trader Analyzing Data
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Finally, a lot of short sellers trade with a margin account or using leveraged instruments like futures or CFDs. This means losses are magnified and traders shorting a stock can only take limited losses. These three factors mean that most traders who are short selling stocks are prone to cover losing positions quickly. They will usually base their decision to cover their position on their P&L, rather than on the price of the stock. By contrast, long term investors often base their decision to close a position on the price or fundamentals.

As short sellers begin to repurchase the shares the price rises, forcing other short sellers to cover. A small amount of initial buying can therefore set off a chain reaction, creating a sudden and sustained rally. A short squeeze will often attract momentum traders on the long side, and eventually the price will rise too far. The downtrend will then resume when long positions begin to liquidate, and no buyers remain. A short covering rally can therefore create opportunities for traders to profit from the rally and then shorting a stock when the downtrend resumes.

Trading strategies for short sellers

Stock Trading Strategies
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When searching for stocks to short, you should be aware that there are several different occasions when shorting a stock can be appropriate. These can occur during both bull and bear markets. The first opportunity is to sell stocks that are generally weak but have followed sector leaders higher. The time to do this is when the sector or a major index reaches a bullish extreme. If the market retraces, the weaker stocks will fall the most.

As mentioned, short squeezes can offer two opportunities to profit. To find a good short squeeze candidate, look for stocks with negative sentiment and high volumes that have declined substantially. Then wait for a larger than average positive move to trigger a squeeze. Short sales can then be made when it appears that most of the shorts have covered, and momentum traders are beginning to liquidate their longs.

You can also look to sell stocks short when they break a major support level and if you believe a large number of stop losses will be triggered. When using this strategy its worth shorting stocks that have not been widely shorted by others. Shorting a stock while simultaneously holding a long position in an index or sector ETF allows you to profit if that stock underperforms the market or its sector. You can also sell an index ETF or futures contract short and buy an individual stock to bet on that stock outperforming the market.

Risks of short-selling stocks

Scared Trader / Investor
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While short selling stocks can be very profitable, it can also be risky. Losses are theoretically unlimited and short squeezes can result in losses piling up very quickly. Overnight gaps are a big risk for short sellers. If news that is positive for a stock price breaks after the market closes, the price can open a lot higher the following day. As stop losses are triggered, short covering can lead a stock price to rise further – often to irrational levels. Large trading desks are often aware of the most shorted stocks and will take every opportunity they can to engineer a squeeze. If liquidity is low, it is very easy to trigger a rally that prompts short covering and a squeeze from those shorting a stock.

The funds that lend stock can recall the stock at short notice. This means anyone that borrows shares from that lender must return those shares. If a large fund that has lent out stock decides to sell its holding, a short squeeze will occur – even though the fact that they are selling the stock should be bearish for the stock. Every trader that has been shorting stocks that are recalled will then have to cover their position and return the stock to the lender. The downtrend will then resume when the fund does begin selling the stock.

Shorting penny stocks is particularly risky for two reasons. Firstly, penny stocks have low liquidity which can lead to very sudden large price moves. Penny stocks can easily move 30% or more in a day. They are often tightly held with only a small amount available for short sellers to borrow.

How to manage risk on a short sale

Risk / Reward Ratio
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When it comes to short selling stocks, timing is often everything. There is a much smaller window of opportunity when shorting a stock, than when buying. You need to consider the amount of volume trading (ideally it should be rising) and whether other sellers are likely to be selling short or liquidating longs. Ideally you want to be shorting a stock ahead of long positions being liquidated.

If you are not one of the first to open a short, it may not be worth taking the trade. As more traders short the stock, so the risk of a squeeze grows. Before shorting a stock always check how much of the issued stock has already been shorted. You can check this on stock screener websites like Finviz. Anything above 10% is relatively high. If more than 20% of the float has been sold short, the trade is likely to be crowded.

Stop losses must be managed and followed even more carefully when short selling stocks. As mentioned, when short selling stocks, potential losses are unlimited. For this reason, it’s worth reducing your trade size when shorting a stock. To make up for the smaller trade size, you should focus on short selling stocks that have a long way to fall.

Conclusion 

Short selling stocks can be profitable if done correctly. This is not always easy and carries significant risks. However, for investors the advantages of short selling are the ability to profit from relative return trades and invest in market neutral funds. This enables long term investors to generate alpha without exposing an entire portfolio to market risk.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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