The ins and outs of short selling

Short selling allows traders to profit from a fall in the price of an asset and it’s a strategy that opens up more opportunities, particularly in volatile markets.

Source: Bloomberg

Traders look for opportunities to grow capital, and this means increasing exposure to a range of tradeable financial instruments and also to a range of trading strategies. Short selling allows traders to profit from a move lower in an asset and opens up a whole world of opportunity.

Short selling is in effect the exact opposite from buying, or going long. The process of short selling may seem daunting, particularly short selling stocks, but it isn’t complicated. The mechanics differ by asset type and many market participants will be already be comfortable with shorting a currency or index.

Hedge funds have been using short selling strategies for years, some successfully, others less so. The range of strategies they employ are vast and some extremely complicated, but retail traders can replicate the principals they employ. The majority of hedge funds use leverage to try and magnify potential returns, but also use short selling in a risk management capacity. To be a successful speculator of financial markets one has to be a manager of risk first and foremost.

The mechanics behind short selling

Simply put, once a trader fills in a deal ticket with their desired trade perimeters and hits the ‘sell’ button, IG will ‘lend’ the stock to the client and effectively sell this into market on the clients behalf. An over-the-counter (OTC) agreement is made to exchange the difference between this opening price and wherever the client chooses to buy back.

If the stock falls in price the client can buy back to close for a profit, or if price goes higher then they may buy back for a loss. In terms of risk management, stop losses are placed above the entry price because the trader wants the price to fall. As with any equity CFD trade, the client can chose to trade this position directly into the market (DMA) or ‘market maker’, where IG will internally match off the clients sell order with another client’s buy order (this is called ‘internalising’ flow).

The best time to look at shorting

There is no better time to consider shorting stocks than when uncertainty in the market is high and volatility increases. The US volatility index, commonly known as the ‘VIX’, is a great place to assess volatility, but it can also be seen in daily stock trading ranges and the five-day average true range (ATR).

When volatility rises, a deflationary mindset takes hold and market participants feel that there is high probability of buying at cheaper levels. Asset managers and pension funds who hold a mandate to only go long will generally pull their buy orders and liquidity tends to thin out. This is often labelled a ‘buyer’s strike’ and this is exactly where short sellers will come out to play, as prices tend to drop more aggressively as funds can have a greater influence on price.

Traders will also short sell a stock or an asset after a strong run in an effort to pick the top. This is generally a low probability set-up if it isn’t accompanied by strong signs of price reversal, and when it comes to short-term trading aligning the directional bias with the trend increases probability greatly. There are ways traders can trade reversals on markets very successfully, but it generally means waiting for price to confirm a move lower. In this situation, it is advantageous to initially start with a small position and add to it as and when a trend develops.

In an environment when an asset has had a really strong move, traders will often look at reversion to a mean. There are many methods of looking at this, but often traders will use technical indicators such as Bollinger bands and change the upper and lower bands to 2.5 standard deviations from the mean (the 20-day moving average), and perhaps combine this with the 9-day Relative Strength Index at very elevated levels of over 80. From here let price dictate and guide. If prices struggle to push higher the next day and the bears wrestle back control and technically we see confirmation of a reversal, then this can be a strong short sell signal for convergence to a mean.

Another higher probability strategy is to simply short a stock that is trending lower. Whether there are issues specific to the company, or the stock is just getting caught up in a macro sentiment, if an asset is trending then weakness often breeds weakness and this should frame the trading bias. If a stock is trending lower, the company has structural issues (perhaps they have a deteriorating balance sheet) and implied market volatility is elevated, then this is the perfect time to look at short strategies.

Other key considerations

Keep in mind that in most cases traders will tend to hold short positions for a shorter duration than long positions. In markets, moves lower can often be more aggressive and the daily ranges wider than moves higher. This can be huge consideration for risk and money management as it could be advantageous in this environment to run a wider stop and keep position sizing low. 

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