Many investors and traders profit from bull markets. They invest in companies they expect to grow based on optimistic views. However, some traders attempt to profit from declining share prices, struggling businesses and market crashes. These traders are known as “short sellers” and prefer to profit from negative market sentiments, such as a bear market.
There are various ways to short a stock. In this article, we investigate how to short a stock via leveraged trading, and key signals when deciding what stock to short. Shorting stocks is more complex than trading based on optimistic market attitudes. Therefore, it is important to understand how to get started short selling and the implications of doing so.
What does shorting a stock mean?
Most investors aim to benefit from stocks that are forecasted to have the potential for future growth and development. However, short selling or shorting stocks is a trading technique that involves profiting from the decline of a company’s share price.
Traders who follow conventional trading strategies are usually looking for markets that are becoming more relevant or companies that are outperforming the market average. They could also be looking for momentum or sentiment around an industry. However, short-sellers do the opposite. They look for shares that are underperforming in the market or shares that could become less relevant in the near future. They might also be looking at stocks that have unnecessarily run ahead of the market or its peers. They could be looking at leading indicators that could see the stock pull back, they could look for frauds or lawsuits or anything that may negatively impact the stock
How does shorting a stock work?
CFD
When traders short sell a stock using CFDs they do not own that underlying instrument. Shorting a stock via a CFD enables you to speculate on the potential decline in price on a range of asset classes such as shares, indices, commodities, currencies and treasuries. CFDs are a leveraged product, which means that you only need to deposit a small percentage of the full value of the trade in order to open a position. This is called ‘trading on margin’. While trading on margin allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the position.
Example scenario of short selling stocks
For example, let’s say that you wanted to short US stock Apple (AAPL) via CFD trading.
Apple is currently trading at $300.
You open a position by "selling" 10 units of AAPL at an opening price of $300. Your total notional exposure would be $3000.
CFDs are leveraged, meaning you only need to pay a deposit of the full trade amount to open the trade. The margin rates for shares are 20%, meaning your margin requirement is just $600 (20% of $3,000).
How to find stocks to short sell
Finding the right time to short a stock can be the difference between good and bad short selling. Generally, it is dependent on a trader’s strategy to find effective market entry and exit points. Most traders will use a combination of strategies to determine when they will enter the market, but it varies distinctly between technical analysts and fundamental analysts.
Technical analysis
Technical analysts could short a stock based upon what direction the general trend is heading. Using simple trend line indicators, technical analysts would analyse the trend direction of a share or stock. If the trend showed no signs of slowing down, it would present a key opportunity for technical analysts to ride the trend downwards.
Technical indicators such as the simple moving average (SMA) or exponential moving average (EMA) can provide key insight for technical analysts. Stocks that drop through prominent support points or fall below major moving averages (e.g. 200-day moving average) may continue on a descending trend.
Fundamental drivers
Missed earning reports present a big opportunity for short-sellers. If a company profit does not meet profit estimations, it is likely to be underperforming in certain areas. This could cause a large number of investors to start short selling. However, it is often best to look beyond just earning reports, as a company may be underperforming for reasons that do not impact its stock price.
Declining industries provide another opportunity for short-sellers. Industries that have experienced a general downtrend due to innovations in other markets or negative client sentiment can cause a particular stock’s price to plummet. This can also be affected by political and economic events such as presidential elections and trade wars. When an industry is perceived as obsolete, companies in that competitive space can be left with dwindling growth prospects, causing short sellers to take advantage.
Overvaluation is a common factor that can cause short sellers to come together. Stocks that are constantly covered in the news can cause the price to hyper-inflate relative to the stocks actual value. Once the stock market bubble bursts, short sellers will come together knowing that the stock is not worth its current market value.
However, please note that a stock’s fundamental values are not sole determinants of its price. There are various factors to consider when shorting a stock, and these factors form a complex picture. Each trader should do their own research when considering to trade stocks.
Famous examples of short selling
Jim Chanos and Enron
Jim Chanos is a legendary (or notorious, depending on your perspective) short seller who was one of the first to pick up on the trouble brewing at US energy giant Enron. When the wheels came off the company and everyone released its senior management had been cooking the books, its share price collapsed and Chanos’ firm Kynikos picked up a $500m profit.
The US sub-prime crisis
As documented in The Big Short, a number of investors saw the trouble on the way in the US housing market and wisely bet on the failure of mortgage bonds via credit default swaps and walked away with massive profits.
Benefits of shorting a stock
Hedging risks. Using short selling to offset the risks of other assets in your portfolio is a known strategy for savvy long-term investors. Hedging your other positions by short selling can reduce your overall risk exposure. Say, for example, you purchased some shares in Google and intended to hold them for 10 years to profit from the companies expected growth. If any short-term disruptions impacted the rising trend of Google share price and it started to fall, you could hedge your investment position by short selling. This way, any losses that exist for Google's shares can be reduced by the profits of the short sell.
Opportunity. Most financial markets are volatile and sensitive to external forces. Having the opportunity to take a position on both sides of the market can be more useful than only having access to buying opportunities.
Market crashes and recessions. Short selling provides one of the few opportunities to profit from declining markets and recessions. Without having the ability to short a share, profit opportunities would be limited to periods of market growth.
Risks of shorting a stock
Limited profit and unlimited loss. When shorting a stock through a broker the maximum profit you can make is limited as a stock cannot surpass being worthless. Additionally, losses can be hypothetically unlimited as there is no limit to a rising stock price. However, when leveraged trading, the use of stop-loss orders can be used to manage this risk.
How to make money selling stocks short
Short selling can provide a great opportunity for many traders, as being able to play both sides of the market increases the chance of finding markets that match your trading strategies. Additionally, the ability to short a stock via a leveraged trading product provides a more streamlined process in comparison to conventional methods to short a stock.
When learning to short a stock, you must take into account the risks that arise with leveraged trading. Features such as guaranteed stop losses and negative balance protection can be particularly useful when attempting to mitigate your risk exposure. These features can provide a larger margin of error in comparison to conventional short selling.
When considering CFD trading ensure you consider all risks and fees involved. View all fees here.