What is Short Sale? How To Use To Earn More?

What is Short Sale

The short sale (short selling) allows traders to benefit from the fall in the price of a stock or other asset on the exchange. This is what the "bears” do when they expect negative scenarios.

Short selling, or just short selling, is a strategy used by some traders to anticipate a price drop. It is considered a bearish position.

  • How does short selling differ from long selling?
  • Why does short selling bring unlimited risk?
  • In which cases is short selling used?

O long is the term used in the financial world to designate the purchase position of any asset.

Read the answers to short selling related questions in this article, written by professional traders.

What is short selling (short selling)? Definition

To explain what short selling is, we'll start with the long one (profiting from a growing market), because it's simpler. Let's assume you bought AAPL shares. Therefore, you have taken a long position. This means that you have spent money on purchasing a financial asset. The increase in its value (shares of AAPL in your case) will be good news for you.

Long is when you expect to profit from the rise in the asset's price, and short is the opposite — with its decline.

Short selling is a financial transaction in which a trader borrows a financial asset with the aim of selling it at the current market price. As a rule, the broker or investment bank that has signed a partnership agreement with such broker is the creditor in this case.

Closing a short position means buying back the financial asset to return it to the lender. The difference between the prices is the profit (or loss).

Example. You know that, statistically, AAPL shares fall in price in September after the presentations of the new iPhone, overheated by expectations. And you want to profit from that knowledge.

You borrow 100 shares of AAPL the day before the presentation and sell them at the market price—$150. After the presentation, you learn that the share price has actually fallen, as investors' expectations have not proved correct.

You close your short position by buying 100 shares of AAPL at $148 each. You return the shares to the broker. Roughly speaking, your profit, excluding commissions and fees, is 100 × 2 = $200.

The lender earns from the interest rate on the shares you borrowed.

When do traders use short selling?

When do traders use short selling?

We have already analyzed one of the short selling options using the example above, that is, opening a short position on the eve of the news, if you believe that the news will cause the price of the financial asset to fall.

News leading to the opening of many short positions also includes changes in central bank policy, news about wars, disasters, court rulings, layoffs of civil servants, etc.

Below are several other reasons to open positions Short (profiting from a falling market) this list certainly doesn't cover the huge amount of possible reasons.

bear market

The economy is cyclical. Periods of explosive growth alternate with recessions. And no matter what the specific news is, the big picture of the stock market sometimes fits into the structure of a declining channel. As the “trend is your friend”, the positions Shorts will be preferable in this case.

Trading against market sentiment

If you monitor market sentiment using indicators of brokers' client positions, you can see that most are overly bullish when the market peaks. By determining this moment, you have a reason to open a short position.

Trading Signals

Os trading signals are recommendations for opening a position, sent (free of charge or for a fee) by different providers — private traders, companies, financial advisors.

Each popular stock on the exchanges has its own rating. If analysts recommend SELL, it is a reason to open a short position.

Trading correlated assets

Let's say you know that the metals — silver, gold and platinum are correlated to some degree.

If you can see the SELL signals on different technical indicators for different metals, you can open a short position on the metal that is acting weaker than the others, thus increasing your chances of ultimate success.

opening positions Shorts for risk coverage (portfolio insurance) deserves a separate article. We will address this problem below.

Long vs short position

  • Long means immediate purchase of an asset with the aim of selling it later at a high price.
  • Short means borrowing an asset and selling it immediately with the aim of repurchasing it later and at a lower price, and returning it to the lender.

What are the other differences and quirks?

  • Short positions are traditionally seen as posing higher risks.

Prices for exchange assets range from 0 to infinity (if you discount the cases of negative prices for oil futures amid the COVID-19 pandemic in 2020).

So if you are taking a long position, it means that:

  • Your loss is limited to the price at level zero
  • Your profit is unlimited

In contrast, if you are taking a short position, it means that:

  • Your profit is limited to the price at level zero
  • Your loss is unlimited. If the price goes up, your account will be emptied. Your broker has negative balance protection, right?

As an example, we will use the situation with GME stocks. In 2020, professional hedge fund managers decided it was a fundamentally weak stock and cut it down.

However, in 2021, a group of Reddit investors agreed to buy shares. The price soared and caused huge losses for hedge funds. This story became the subject of lawsuits.

When discussing the short position, it is reasonable to refer to such a condition as a short squeeze. What does that mean?

The short squeeze is a movement in the financial market that causes an asset to appreciate in a very significant way.

When a group of traders is forced to close unprofitable short positions, in doing so they create demand and push the price even higher.

The more short positions are closed, the greater the strength of demand. This is how GME stocks managed to grow so quickly despite the weakness of fundamental indicators.

Another well-known short squeeze happened in October 2008, when Volkswagen shares soared in price as brokers tried to cover short positions in its shares. As a result, the price rose from around EUR 200 to EUR 1.000 in one month.

Why are short positions more common on Forex?

The Forex market is unique not only because it is the largest and fully decentralized (the market does not have a physical address and trading is carried out electronically).

Any position in the market can be seen as short against one currency and long against the other currency.

For example, you funded your account with the broker in euros. And you bought 1 lot of USDJPY. The fact that you opened a long position against the dollar also means that you sold the JPY.

Can short positions be opened in all markets?

Do not. If we are talking about spot markets, financial markets, there may be restrictions. For example, not all brokers allow you to open short positions in stocks.

They calculate the risks and may decline if:

  • Shares are not liquid;
  • The client does not have a professional status.
    There may also be limitations on some stocks, such as reduced leverage or a ban on holding the position overnight (rollover).

The other example is the bags of criptomoedas. On some local platforms, you will not be able to short sell Bitcoin, but only buy the coin and put it in your account to hold it and then sell it.

However, as Bitcoin price actively moves in both directions, there are a large number of traders willing to sell it short. To meet this demand, cryptocurrency exchanges have introduced futures trading, derivatives tied to the Bitcoin rate.

Futures are highly speculative as they have several advantages:

  • You can use them to open long and short positions;
  • Futures trading is charged with low commissions;
  • Futures markets allow for leveraged trading;
  • Futures markets are rich in liquidity;
  • Some futures have longer trading sessions than the underlying assets linked to them.

Main types of short positions

Let's review 3 types of short positions, depending on the trader's reasoning.

  • speculative shorts

Let's assume you are signed up to trade cryptocurrency signals. You receive the following message on Telegram:

This is the reason for opening a short position in the cryptocurrency market — in this case, the provider assumes that the price will fall from the downline and will go down 10 – 20%.

Whether that will happen or not is a different question. In this case, however, you are acting like a speculator, reaping benefits from trading based on technical analysis of signals.

  • coverage risks

Let's assume you are a long stock investor, but you see that the stock markets are moving towards the correction.

To calmly 'stay out' the correction, you open a short position in stock index futures. The decrease in the value of the portfolio is offset by the profit from the short position and can even substantially improve your efficiency if you successfully cover the short position with minimal correction.

Forex short selling

Let's assume you are holding a position in USDCAD. This means that there are two factors that influence your position: US dollar strength/weakness + Canadian dollar strength/weakness.

If you think about it, you are always holding a long position in one currency and a short position in the other. So when it is morning there is important news for each currency scheduled to come out on the economic calendar, you want the good news for one currency and the bad news for the other.

Short selling summary

Short selling is the borrowing of financial assets with the aim of selling them immediately at current prices.

A broker who opens a short position expects prices to fall in the future, they buy the assets back at a lower price, return the debt and make a profit.

Short selling allows traders to benefit from the fall in the price of a stock or other asset on the stock exchange. This is what “bears” do when they expect negative scenarios.Short selling FAQs

 

Who can be involved in short selling?
Short selling is normally available to all brokerage clients, although there may be restrictions on some instruments.
Is short selling a risky type of trading?
All transactions in the financial markets carry a risk. Short selling is no exception. This carries slightly greater risks than long selling. However, if you follow a tried-and-true strategy and observe risk management rules, opening short positions generally allows you to benefit more in the financial markets.
How much does it cost to open a short sale?
It depends on the broker's conditions. Consult the broker's customer support about the margin fee. Most likely, it will vary depending on the markets, the size of the short position and other factors.
If I am ordering assets, when should I return them?
You can take as long as you need. A short position can be forcibly closed if you are no longer financially able to maintain it. Or, if the broker has borrowed the assets in question from a third party to lend them to you and the third party has requested that the assets be returned, the broker may terminate your position if there is no other way to obtain the assets elsewhere.
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