Short Selling (Short Selling)

Short Selling (Short Selling)

The term “short selling” comes from the stock market. Short selling is the sale of a stock that does not belong to the seller.

Therefore, in order to be able to sell it, the seller had to “borrow” the stock from a third party, usually an online broker.

When closing the transaction by purchasing the shares, the trader can return them to the broker who lent them to him and get a benefit, as the amount he pays to buy these shares is less than the amount he received from selling them.

To better understand this, let's consider the following example:

A broker believes that shares in Banco Santander, which is trading at 5 euros, will decline in price. Therefore, he borrows 1.000 shares and sells them.

The trader receives, excluding commissions, 5.000 euros for the sale of shares. However, the trader is now “short” on 1.000 Santander shares, as he has already sold something before owning them and will therefore have to return them to the creditor.

A few days later, Banco Santander publishes its earnings report for the quarter and the results are worse than expected.

As a result of this information, the share price ends up trading at EUR 4,5. At this time, the trader decides to close the short position and buy the 1.000 shares on the stock exchange to replace the borrowed shares.

This purchase, excluding commissions, costs the trader EUR 4.500. The trader's profit for the short sale, without taking into account the transaction's commissions and interest, would then be EUR 500, which is the difference between the money he received for the sale and the money he needed to buy the shares.

It is clear, therefore, that in a short sale of shares:

  • Profits will increase the greater the fall in the stock price.
  • Losses will increase the more the share price rises from the price at which the sale was closed.

That said, in a short sale of shares, the potential gains are limited by the price of the share itself (if a share trades at €5, it can never drop more than €5).

On the other hand, however, the potential losses are theoretically unlimited, since there is no limit imposed on the upward movement of the share price.

For this reason, in these types of trades it is always essential to establish “stop-loss” levels to limit the potential losses that can occur if the market does not move in the same direction as the trader's expectations regarding a fall.

Short selling can be produced by speculation on the stock price, as in the case of the example, or also by a desire to hedge the downside risk of a portfolio that contains the same or others that are correlated with those to be sold. uncovered.

Short selling in trading

In trading, the term short selling or short position is generally used to open short or short positions, not just for stocks, but for a wide variety of assets such as stock indices, currencies or commodities.

For example, if a trader invests in oil, the sequence would be similar to the one explained in the previous point, but adapted to the trade:

  • At a given moment, at the opening of the currency market, the barrel of Brent is trading at $44,50.

 

  • If the trader believes that the price will go up, he will open a buy position, and if the price goes up to $45,50, his profit will be $1 for each unit sold.

 

  • If, on the contrary, the trader believes that the price will fall, thanks to short selling, the trader can act as a seller; therefore, he will open a short position for this instrument.

 

  • If the price drops by $43,50 and you close the position, your profit will be $1 for every unit sold. By closing the position, you are “buying” the instrument at a better price than the asking price.

How to choose the best time to open a position?

One of the keys to successful bear orders or uncovered positions in trading is knowing how to choose the best time to open a position.

In the stock market, down moves in stocks are normally much faster than moves up, so a trader who opens a short position too late may miss out on much of the stock's move.

On the other hand, opening an uncovered position too early can be difficult to sustain if the stock price continues to rise.

As can be seen, the choice of when to trade short is a critical variable. Some of the factors that can help you choose the best time to trade are:

 

  • Main trend direction. If the main trend of the stock or asset is down, there is a higher probability that the trade will be successful.

 

  • Deterioration of fundamental factors. A progressive deterioration of the fundamental factors that affect the price of the asset on which it will trade normally anticipates downward price movements.

 

  • Low technical signals. Using the tools provided by technical analysis is crucial to confirm downward movements in the price of an asset.

Some technical signals associated with bearish moves are:

  • Price increases as trading volume decreases.
  • Price movement below support levels.
  • Training the trend changes like a shoulder-to-shoulder head.
  • Crossing the short-term moving average below the long-term. For example, crossing the 50-day moving average below the 200-day moving average.

Advantages of short selling

Short selling in trading has many advantages that appeal to many traders, whether they are beginners or experienced:

  • Short selling gives traders access to instruments they would not otherwise be able to trade. If a trader wants to take advantage of a reduction in the value of an instrument, he can do so even without owning it.

 

  • Trading with an instrument (for example, Bitcoin or Ethereum) by opening a short (sell) position allows traders to profit even when markets are falling.

 

  • In short sales, the trader can supervise and control his investment using different market orders to minimize costs and carry out adequate risk management.

 

  • Similar to buy operations, the trader can use short selling and open positions with his capital.
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