Selling (Going Short) Oats Futures to Profit from a Fall in Oats Prices

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Contents

How Falling Stock Prices Can Make You Rich

When buying stocks, falling market prices are your friend

Falling stock prices cause panic in some investors, but fluctuations in the market represent business as usual. Investors who are comfortable with this reality know how to respond to falling prices and how to recognize assets that are good buys when stock prices are dropping.

Ignoring Your Instincts

Human nature is to follow the crowd, and investors in the stock market are no different. If prices are going up, the kneejerk reaction might be to hurry up and buy before prices get too high. However, this often means that you’re rushing to buy a stock for, say, $50 today that you could have purchased for $45 yesterday. When thinking about it that way, the purchase seems less attractive.

The opposite also is true. If prices are falling, people often rush to get out before prices fall too far. Again, this might mean that you’re selling a stock for $45 that was valued at $50 yesterday. That’s no way to make money, either.

While specific events or circumstances can cause stocks to spike or plummet and force investors to take quick action, the more common reality is that day-to-day fluctuations—even the ones that seem extreme—are just part of longer trends.

If you’re in the market primarily to build your nest egg, the best course of action almost always is to do nothing and let the long-term growth take place. If you’re trying to quickly build the value of your business or your portfolio, though, seeing other people in a rush to sell a falling stock might be your cue to jump in against the current and buy. Consider how that can work for you. 

3 Ways to Make a Profit From Investing

When you buy a stock, you are purchasing a small portion of a company. Profit from such a purchase comes from three different sources:

  • Cash dividends and share repurchases. These represent a portion of the underlying profit that management has decided to return to the owners.
  • Growth in the underlying business operations, often facilitated by reinvesting earnings into capital expenditures or infusing debt or equity capital. 
  • Revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings. 

An Example

Imagine that you are the CEO and controlling shareholder of a community bank called Phantom Financial Group (PFG). You generate profits of $5 million per year, and the business is divided into 1.25 million shares of stock outstanding, entitling each of those shares to $4 of that profit ($5 million divided by 1.25 million shares is $4 earnings per share).

If the stock price for PFG is $60 per share, that results in a price-to-earnings ratio of 15. That is, for every $1 in profit, investors seem to be willing to pay $15 ($60 divided by $4 gives us a p/e ratio of 15). The inverse, known as the earnings yield, is 6.67% (take $1 and divide it by the p/e ratio of 15 to give us 6.67). In practical terms, you would earn 6.67% on your money before paying taxes on any dividends that you’d receive even if the business never grew.

Whether that return is attractive depends on the interest rate of a U.S. Treasury bond, which is considered the “risk-free” rate.     If the 30-year Treasury yields 6%, you’d be earning only 0.67% more income for a stock that has lots of risks versus a bond with virtually none.

However, PFG management is probably going to wake up every day and show up to the office to figure out how to grow profits. That $5 million in net income that your company generates each year might be used to expand operations by building new branches, purchasing rival banks, hiring more tellers to improve customer service, or running advertising on television.

If $2 million is reinvested in the business, that could raise profits by $400,000 so that next year, they would come in at $5.4 million—a growth rate of 8% for the company as a whole.

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Another $1.5 million paid out as cash dividends would amount to $1.50 per share. So, if you owned 100 shares, for instance, you would receive $150 in the mail.

The remaining $1.5 million could be used to repurchase stock. Remember that there are 1.25 million shares of stock outstanding. If management goes to a specialty brokerage firm, buys back 25,000 shares of their own stock at $60 per share, and destroys it, the result is that now there are only 1.225 million shares of common stock outstanding. In other words, each remaining share now represents roughly 2% more ownership in the business than it did previously. So, next year, when profits are $5.4 million, they will only be divided up among 1.225 million shares making each one entitled to $4.41 in profit, a per-share increase of 10.25%. In other words, the actual profit for the owners on a per-share basis grew faster than the company’s profits as a whole because they are being split up among fewer investors.

If you had used your $1.50 per share in cash dividends to buy more stock, you could have theoretically increased your total share ownership position by around 2% if you did it through a low-cost dividend reinvestment program or a broker that didn’t charge for the service. That, combined with the 10.25% increase in earnings per share, would result in 12.25% growth annually on that underlying investment. When viewed next to a 6% Treasury yield, it’s a fantastic bargain.

Some Good News When the Stock Falls

However, what if the price of the stock falls from $60 to $40? Although you are sitting on a substantial loss of more than 33% of the value of your holdings, you’ll be better off in the long run for two reasons:

  • The reinvested dividends will buy more stock, increasing the percentage of the company you own. Also, the money for share repurchases will buy more stock, resulting in fewer shares outstanding. In other words, the further the stock price falls, the more ownership you can acquire through reinvested dividends and share repurchases.
  • You can use additional funds from the business, job, salary, wages, or other cash generators to buy more stock at a cheaper price. If you truly are focused on the long-term outlook, the short-term losses are less significant. 

A Few Persistent Risks

While most long-term stockholders don’t need to fear sudden dips, there are a few risks that can cause serious issues.

It’s possible that if the company gets too undervalued, a buyer might make a bid for the company and attempt to take it over, sometimes at a price lower than your original purchase price per share. This is essentially the same thinking that you may apply when you buy more shares during a dip, but since they’re doing it on a larger scale, they could push you out of the picture altogether.

If your personal balance sheet isn’t secure, you might suddenly find yourself needing cash. If you don’t have it on hand, you could be forced to sell shares at massive losses. You can avoid this scenario by not investing any money that could be needed in the next few years.

People overestimate their skills, talent, and temperament. You might not pick a great company because you don’t have the necessary accounting skills or knowledge of an industry to know which firms are attractive relative to their discounted future cash flows. If that’s the case, the stock may not recover from a sudden drop.

Understanding short trade

Short selling is a means of trading when you think the price of an asset is going to fall. It turns conventional investing on its head in that you sell before you buy. And many new instruments, such as contracts for difference (CFDs), have made shorting an asset easier.

You can now short an asset on a mobile trading app by simply hitting the sell button when you think the asset price is about to drop or when it is already dropping.

But be warned: speculating by going short is a high-risk activity. It typically has a short-term time horizon and you need to watch out for the price turning around and rising again.

Contracts for difference (CFDs)

Short selling has been around for about 500 years, but the more modern way to short an asset is via contracts for difference or CFDs.

CFDs are a type of derivative that mirror the performance of a share, index, currency pair or commodity price. They can easily be accessed from a mobile phone or tablet and are available whenever the markets are open.

A CFD is an agreement between the trader and the provider to exchange the difference in value of the share or other assets at the start of the contract (open position) and the end of the contract (close position). This is usually a fixed period and often just within one day’s trading – there are usually extra costs to holding a CFD overnight.

Using CFDs you can sell ABC Car Company at £10 and buy it back at £9 just as you can with the shares, only with CFDs there is no need to borrow the shares before you sell them – as you must do with traditional short selling. That also means there is no corresponding fee to do that.

CFDs also have the advantage of not attracting stamp duty, which trading the physical stocks and shares does.

Leverage

Leverage is a key feature of CFD trading. It means that you only have to tie up a small percentage of your total position. Say you have £1,000 to invest and there is leverage of 10:1 you could invest the equivalent of £10,000.

If all goes well your investment is 10 times as profitable. If it doesn’t go well, your losses are magnified 10 fold.

The scale of potential losses can be capped by having a stop loss order on the deal to stop it at a predetermined point.

Margin

Short selling usually needs a margin account. This has two elements

  • Maintenance margin – the amount overall you can risk in all your trades
  • Deposit margin – the percentage of the full value of the trade for that particular asset

If the trade doesn’t go as well as you’d hoped, you could lose not just your deposit margin but eat into your maintenance margin.

If the funds in your account are insufficient, the provider will require them to be topped up. This is known as a margin call.

Margin calls can happen when your losses are at 20% of your maintenance margin. At 50%, your trades will be closed as quickly as possible to try to stem your losses. But you risk losing all you have deposited and more (unless your broker guarantees that will never happen).

Shorting the CFD markets

With CFD trading the deposit margin is the percentage you have to pay to open the contract. The percentage will vary depending on the volatility of whatever is being shorted. For example the margin on a highly volatile asset, such as Bitcoin, can be as much as 50% during its most volatile periods, while on blue chip shares it may be as little as 2%.

You short 1,000 CFDs at £10 a share. The margin on the shares is 10% so you pay just £1,000 instead of £10,000.

The shares fall to £6 and you end the contract. You have made £4,000 profit minus any fees.

If, however, the share price rose £2 you would end the contract with the shares at £12 and you would lose £2,000 on the contract.

You must to be able to settle this amount from your maintenance margin account. That means your maintenance account would need to have at least £10,000 in it and you’d be close to a margin call. However, if you had other trades that were successful and your overall net loss was, say £500, you’d be OK.

Note: Short selling CFDs without leverage and margin will soon be possible on the capital.com trading app.

Stop loss orders

One way of protecting yourself from losses is to have a stop loss order in place. These work for both going long and short. Going short you place a stop loss order to trigger if the price moves against you – starts to go long, or rise instead of fall.

In our example, you might set a stop loss order at £10.25. This would begin exiting as soon as the price hit £10.25, ideally capping your losses at £250.

You can also have trailing stops, so that as your short position proves successful a new stop loss level is placed to prevent any rise in the price wiping out your gains. Stop loss orders are well worth considering.

Not just shares

As CFDs mirror the price of stock market indices, currency pairs, commodity prices and cryptocurrencies, as well as shares, you can go short on these as well.

Even if the trend is upward, few prices rise on a smooth curve and there are often significant falls in price that a short seller can capitalise on.

For example on 20 December 2020 you could have taken advantage of a dip in the NASDAQ 100 when it fell 25 points in morning trading before continuing on its general upward direction.

But short selling started with traditional shares.

Traditional short selling of shares

The conventional way of investing in shares is to buy them and then hold on to them until they rise to a price at which you are happy to sell them. This is fine if the price will be higher in the long run. This is known as long selling.

But shares don’t always increase in price. What if there is a fair chance that the share price will fall, perhaps because some bad news about the company is about to come to light?

This is where short selling can be a valuable investment tool. You are still aiming to buy low and sell high, but just in the reverse order – you sell the shares at the high price first and buy them back at a suitable lower price later.

Open a trading account in less than 3 min

Short selling used by Investment traders – hedging – to lower risk and generally has a long-term time.

How to short sell markets

How, you may ask, can you sell shares that you don’t own? You borrow them from a broker – for a fee – and then sell them.

Then when the share price reaches a level you are happy with you buy them back and return them to their original owner.

The difference between the purchase price and the sale price is your profit (or loss if things haven’t gone to plan). You will also pay a fee to the broker who lent the shares.

Remember: short selling CFDs avoids having to borrow the shares and avoids the fees to the broker. It is all done by clicking the sell button.

Total recall

Say you have heard more and more reports of a problem with a particular make of car. You think a large-scale recall is a real possibility. This will have an adverse effect on the share price.

For example, Nissan’s share price fell by 5% in October 2020 when it announced that it was recalling 1.2 million vehicles in Japan due to final inspections not being carried out properly.

So you sell 10,000 shares of the ABC Car Company at £10 a share. A week later news breaks that it is indeed recalling thousands of vehicles to fix a fault.

The share price drops to £9. You buy 10,000 shares. You now have a gross profit of £10,000 as you bought the shares for £90,000 and sold them for £100,000.

Upsides of short selling

Short selling’s questionable reputation is not totally deserved and, used well, it has its advantages:

  • Bad news might not be factored into the current price of the stock because, naturally, companies are much more forthcoming with good news about their business than bad news
  • When markets and stock prices fall it is often at a quicker rate than they rise at
  • An overpriced stock may fall to a more realistic value after research by short sellers
  • It helps the liquidity of the market
  • Short selling enables traders to profit from falls in price, not just rises

Downsides of short selling

There are things to bear in mind:

  • There is no limit on the amount you can lose if the share price goes up not down
  • You have to pay any dividends due on the shares back to the original owner when you have shorted them
  • The trend of the market is usually upward and you will need to buy the shares back at some point
  • There is the risk of a short squeeze where the broker asks for the shares back and you have to buy them back at a price that may not be advantageous
  • The cost of borrowing the shares can be high
  • The expected catalyst for the price fall may not happen or take longer to happen than you had hoped

Other issues

It is not just one-off events that can send a share price down. Short sellers also look at companies that:

  • rely too much on one product
  • are making the most of the latest fad or fashion
  • are threatened by new competition
  • have poor financials such as lack of cash flow
  • have price earnings ratios out of step with their growth rates

Marked stock

Seeing what other people are doing is another way of looking for companies whose share price may be about to fall.

Shorted holdings of 0.5% or more of the issued share capital of a company have to be registered with the Financial Conduct Authority.

IHS Markit publishes lists of the amount of stock that is out on loan at any given time. For example, ahead of its interim results in September 2020 nearly 30% of the stock of troubled construction company Carillion was shorted.

When the results were announced Carillion’s stock price fell by 20%. Several companies were shorting Carillion shares before the company went into receivership.

Hedging

As well as speculative investing, short selling can be used for hedging – insurance purposes. Say you have shares in a company that you want to keep long term but you know the industry is about to go through a bit of a tricky patch.

You hold on to the shares but short a similar amount using CFDs so the profit on the short will offset the short-term dip in share price in your long-term investments.

For example, you have 10,000 shares in XYZ bank. Its share price falls from £5 to £4 meaning your investment falls from £50,000 to £40,000. If you could short 10,000 CFDs in the same shares at £5, anticipating the price drop, and buy them back at £4 you would have covered the fall in price.

You would do this using CFDs of XYZ shares, not by shorting the actual shares.

Bad reputation

Short selling tends to hit the headlines for the wrong reasons. It is one thing to wait for the price to go down naturally; it is somewhat different to make the price go down yourself to your own advantage.

If a lot of stock starts to be shorted it can create uncertainty about the financial health of a company. In the financial crisis of 2007-08 short sellers were accused of driving companies such as Lehman Brothers out of business.

To counter this, the FCA can impose bans on the short selling of certain stocks.

Going Dutch

Short selling is far from a new concept. The earliest example is thought to have occurred in the Netherlands in the early 17th century when Isaac Le Maire, a wealthy Dutch businessman, sold shares in the Dutch East India Company.

Le Maire had a questionable motive though as he was a former director of the company and held a grudge against it. He first tried to set up a competitor trading company and when that failed he started spreading rumours about the company to try to send the share price down.

But the share price rose and Le Maire lost a significant amount of money.

Be warned: Short selling does not always work. You risk losing if the share price rises.

Timing

While long selling is often about investment, short selling is much more about timing. Time that sale and purchase back right and short selling can be a valuable addition to your investing armoury.

Time it well with leverage and the gains can be even better.

Short Selling

What Is Short Selling?

Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors.

Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.

In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value by a set future date—the expiration date. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.

Key Takeaways

  • Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
  • Short sellers bet on, and profit from, a drop in a security’s price.
  • Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely.

Short Selling

How Short Selling Works

Wimpy of the famous Popeye comic strip would have been a perfect short seller. The comic character was famous for saying he would “gladly pay next Tuesday for a hamburger today.” In short selling, the seller opens a position by borrowing shares, usually from a broker-dealer. They will try to profit on the use of those shares before they must return them to the lender.

To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also, the Financial Industry Regulatory Authority, Inc. (FINRA), which enforces the rules and regulations governing registered brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin. If an investor’s account value falls below the maintenance margin, more funds are required, or the position might be sold by the broker.

To close a short position, a trader buys the shares back on the market—hopefully at a price less than what they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.

The process of locating shares that can be borrowed and returning them at the end of the trade are handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platforms with most brokers. However, each broker will have qualifications the trading account must meet before they allow margin trading.

As mentioned earlier, one of the main reasons to engage in short selling is to speculate. Conventional long strategies (stocks are bought) can be classified as investment or speculation, depending on two parameters—(a) the degree of risk undertaken in the trade, and (b) the time horizon of the trade. Investing tends to be lower risk and generally has a long-term time horizon that spans years or decades. Speculation is a substantially higher-risk activity and typically has a short-term time horizon.

Short Selling for a Profit

Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 – $40 = $10 x 100 shares = $1,000).

Short Selling for a Loss

Using the scenario above, let’s now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 – $65 = negative $15 x 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.

Short Selling as a Hedge

Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.

The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts. Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain or 7.5%.

Pros and Cons of Short Selling

Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.

However, a trader who has shorted stock can lose much more than 100% of their original investment. The risk comes because there is no ceiling for a stock’s price, it can rise to infinity and beyond—to coin a phrase from another comic character, Buzz Lightyear. Also, while the stocks were held, the trader had to fund the margin account. Even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits.

Possibility of high profits

Little initial capital required

Leveraged investments possible

Hedge against other holdings

Potentially unlimited losses

Margin account necessary

Margin interest incurred

When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if a lot of other traders are also shorting the stock or if the stock is thinly traded. Conversely, sellers can get caught in a short squeeze loop if the market, or a particular stock, starts to skyrocket.

On the other hand, strategies which offer high risk also offer a high-yield reward. Short selling is no exception. If the seller predicts the price moves correctly, they can make a tidy return on investment (ROI), primarily if they use margin to initiate the trade. Using margin provides leverage, which means the trader did not need to put up much of their capital as an initial investment. If done carefully, short selling can be an inexpensive way to hedge, providing a counterbalance to other portfolio holdings.

Additional Risks to Short Selling

Besides the previously-mentioned risk of losing money on a trade from a stock’s price rising, short selling has additional risks that investors should consider.

Shorting Uses Borrowed Money

Shorting is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to a margin call and forced to put in more cash or liquidate your position.

Wrong Timing

Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest, margin calls, and being called away.

The Short Squeeze

If a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions.

Regulatory Risks

Regulators may sometimes impose bans on short sales in a specific sector or even in the broad market to avoid panic and unwarranted selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.

Going Against the Trend

History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

Costs of Short Selling

Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include:

Margin Interest

Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.

Stock Borrowing Costs

Shares that are difficult to borrow—because of high short interest, limited float, or any other reason—have “hard-to-borrow” fees that can be quite substantial. The fee is based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade and is pro-rated for the number of days that the short trade is open. As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intra-day basis, the exact dollar amount of the fee may not be known in advance. The fee is usually assessed by the broker-dealer to the client’s account either at month-end or upon closing of the short trade and if it is quite large, can make a big dent in the profitability of a short trade or exacerbate losses on it.

Dividends and other Payments

The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.

Short Selling Metrics

Two metrics used to track short selling activity on a stock are:

  1. Short interest ratio (SIR)—also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.
  2. The short interest to volume ratio—also known as the days to cover ratio—the total shares held short divided by the average daily trading volume of the stock. A high value for the days to cover ratio is also a bearish indication for a stock.

Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock.

For example, after oil prices declined in 2020, General Electric Co.’s (GE) energy divisions began to drag on the performance of the entire company. The short interest ratio jumped from less than 1% to more than 3.5% in late 2020 as short sellers began anticipating a decline in the stock. By the middle of 2020, GE’s share price had topped out at $33 per share and began to decline. By February 2020, GE had fallen to $10 per share, which would have resulted in a profit of $23 per share to any short sellers lucky enough to short the stock near the top in July 2020.

Ideal Conditions for Short Selling

Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizeable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. Entering the trade too late may result in a huge opportunity cost in terms of lost profits, since a major part of the stock’s decline may already have occurred. On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly.

There are times when the odds of successful shorting improve, such as the following:

During a Bear Market

The dominant trend for a stock market or sector is down during a bear market. So traders who believe that “the trend is your friend” have a better chance of making profitable short sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad, and deep—like the global bear market of 2008-09—because they stand to make windfall profits during such times.

When Stock or Market Fundamentals are Deteriorating

A stock’s fundamentals can deteriorate for any number of reasons—slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins, and so on. For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like the threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth. Experienced short sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.

Technical Indicators Confirm the Bearish Trend

Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. These indicators could include a breakdown below a key long-term support level or a bearish moving average crossover like the “death cross.” An example of a bearish moving average crossover occurs when a stock’s 50-day moving average falls below its 200-day moving average. A moving average is merely the average of a stock’s price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price.

Valuations Reach Elevated Levels Amid Rampant Optimism

Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle “priced for perfection,” since investors will invariably be disappointed at some point when their lofty expectations are not met. Rather than rushing in on the short side, experienced short sellers may wait until the market or sector rolls over and commences its downward phase.

John Maynard Keynes was an influential British economist whereby his economic theories are still in use today. However, Keynes was quoted saying: “The market can stay irrational longer than you can stay solvent,” which is particularly apt for short selling. The optimal time for short selling is when there is a confluence of the above factors.

Short Selling’s Reputation

Sometimes short selling is criticized, and short sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity, meaning enough sellers and buyers, to markets and can help prevent bad stocks from rising on hype and over-optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles such as the mortgage-backed security market before the 2008 financial crisis are frequently difficult or nearly impossible to short.

Short selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news.

Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short selling strategies and derivatives to artificially deflate prices and conduct “bear raids” on vulnerable stocks. Most forms of market manipulation like this are illegal in the U.S., but it still happens periodically.

Put options provide a great alternative to short selling by enabling you to profit from a drop in a stock’s price without the need for margin or leverage. If you’re new to options trading, Investopedia’s Options for Beginners Course provides a comprehensive introduction to the world of options. Its five hours of on-demand video, exercises, and interactive content offer real strategies to increase consistency of returns and improve the odds in the investor’s favor.

Real World Example of Short Selling

Unexpected news events can initiate a short squeeze which may force short sellers to buy at any price to cover their margin requirements. For example, in October 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze.

In 2008, investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock. However, in a surprise announcement, Porsche revealed that they had secretly acquired more than 70% of the company using derivatives, which triggered a massive feedback loop of short sellers buying shares to close their position.

Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn’t interested in selling, and Porsche controlled another 70%, so there were very few shares available on the market—float—to buy back. Essentially, both the short interest and days to cover ratio had exploded higher overnight, which caused the stock to jump from the low €200s to over €1,000.

A characteristic of a short squeeze is that they tend to fade quickly, and within several months, Volkswagen’s stock had declined back into its normal range.

Precious metals investment terms A to Z

Short Selling (also known as “going short” or simply “shorting”) is a way of profiting on lower prices. It’s the practice of selling borrowed (from the broker) assets, with the aim to buy them back later and return to the lender. Short sellers assume that they will be able to buy the stock back at a lower price than they sold short and thus profit.

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Gold Short Selling

The gold short seller profits if the price of the borrowed gold or security goes down – in this situation the investor is able to buy it (gold or other security) back at a lower price. The investor incurs losses if gold’s or this other security’s price goes up – the investor has to spend a bigger amount of money for the buyback. There is no limit to the losses that can be incurred while selling gold short (the price can theoretically rise infinitely), but the potential gain is limited (the price of gold or stock can fall to zero at the most). Going short may also refer to buying a derivative, where the investor profits from the fall in price of the underlying asset such as gold.

Naked Gold Short Selling

Naked short means selling short a security or some other asset like gold without having the asset. For instance, if you sell futures contracts for silver buy you don’t have silver to back up the position. If you had that silver, your losses on the futures contract would be offset by gains on the physical metal. Therefore, this position would be called a hedged (or covered) short futures position. However, if you would sell a futures contract for silver without having silver in the first place, then this position would be purely speculative and since this contract would not be backed by any asset, the position would be called “naked”.

A Brief History of Short Selling

Legend has it that the practice of short selling was invented at the beginning of 17th century by Dutch merchant Isaac Le Maire. It has been a source of controversy and criticism ever since. Shorting East India Company stocks in the 18th century by the London-based banking house Neal, James, Fordyce and Down led to a major crisis, resulting in the collapse of the vast majority of private banks in Scotland and a huge liquidity crisis. Short selling is also responsible for magnifying the Dutch Tulip Crisis.

The term “short” has been used since the middle of the nineteenth century. Short sellers were blamed for the crash of 1929 and this led to the implementation of laws governing short selling. In 1949 a fund that bought some stocks while selling others short hedged some of the market risk – this was the beginning of hedge funds.

Risks of Short Selling

  • No dividend or interest income – contrary to going long, return is taxed only as a capital gain.
  • Limited potential gains, unlimited potential losses – the price of a security can decrease at most to zero (100% potential profit, if going short), but it can increase theoretically infinitely (in this case potential loss of going short is unlimited).
  • A stockbroker may cover (end) a position if the price of the underlying stock rockets without the knowledge of a client in order to guarantee returning borrowed stock.
  • When the stock price rises, some investors who went short decide to cover their positions by buying back stocks thus fueling further price increase.
  • A stock may be “hard to borrow” – a stockbroker may charge an additional “hard to borrow” fee for every day the Securities and Exchange Commission (SEC) declares that the stock is “hard to borrow”.
  • The stockbroker requires a margin account and charges interest, in order to limit the credit risk.

Costs of Going Short

  • Fee for delivering the borrowed stocks – usually it is a commission similar to that of buying a stock.
  • All the dividends are paid to the lender from the account of the person going short.
  • For some brokers the investor going short does not earn interest on the proceeds from short sale.

Buying a Put Option

A very convenient way of going short is by buying a put option, as it limits the short’s potential loss. It is a contract between two parties to exchange some specified asset at a specified price by (in the case of an American option) or on (in the case of a European option) a specified date. The buyer of the put option has the right, but not the obligation, to sell the asset at this specified price and the seller has to buy this asset, if the buyer sells it. If the spot price at the specified future date is significantly lower than the strike of the option, buyers of the options make a profit – they have the right to sell the asset at a price higher than the market price.

We hope you enjoyed reading the above definition of gold short selling. If you’d like to learn more about gold in particular about its most recent price swings and their implications (is it a good time to short gold?), we invite you to sign up for our gold newsletter. It’s free and if you don’t like it, you can easily unsubscribe. Sign up today .

Put Options

A derivative that provides you with leverage during downtrends, while limiting your risk. The catch is that you have to be right on time.

Short-term Trades

Short-term trades are trades that terminate within a short period from their inception. They can be very profitable, but they are also very risky.

Trend

Trend is the general direction – up, down or sideways – in which the price of an asset is heading for a prolonged period of time.

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