What is Short Selling? How to Use Shorts to Earn More?
Unlike the common pursuit of buying low and selling high, short selling thrives on a contrary principle—selling high and buying low. This deviation opens up a vista of opportunities to earn in bearish market conditions, a silver lining when the market clouds gather. However, short selling is not without its share of controversies. It has often been at the heart of financial debates, sparking discussions on its ethical and regulatory implications. And of course, short selling comes with trading risks.
In this article, we'll take a look at how short selling works across different markets like stocks, and Forex. We'll cover the mechanics of shorting, and how to manage the risks that come with playing the short side. You'll learn the key things you need to successfully execute short trades and use shorts to optimize your trading.
What is Short Selling? Definition
Simply put, shorting involves borrowing the asset from the broker, selling it at the current market price, then buying it back later once the price has dropped. If you can buy it back cheaper than you originally sold it, you get to keep the difference as profit!
Example. You know that statistically, AAPL stocks decline 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 AAPL shares on the eve of the presentation and sell them at their market price – $150. After the presentation, you learn that the price of the stock has indeed declined, because the investors’ expectations did not prove to be correct. You close your short position by buying 100 AAPL shares at $148 each. You return the shares to the broker. Roughly speaking your profit, not taking into account the commissions and fees, is 100 x 2 = $200.
The creditor earns from the interest rate on the shares that you borrowed.
Within the broader umbrella of short selling, there exist variations such as naked short selling and covered short selling, each with its own set of rules and risk profiles. Naked short selling, often viewed with skepticism, involves selling shares without borrowing them first, whereas covered short selling entails selling shares after borrowing them, a more regulated and commonly practiced form. Also read how short selling makes (and loses) money in the TU article.
When Do Traders Use Short Selling?
We have already reviewed one of the options for short selling using the example above, i.e. opening a short position on the eve of news, if you believe the news will cause a decrease in the price of the financial asset.
The news items that lead to opening many short positions also include the changes in the central bank policy, news about wars, disasters, court judgments, dismissals of public officials, etc.
Below are several other reasons for opening short positions (this list certainly does not cover the humongous number of possible reasons).
Bearish market
Economy is cyclic. The periods of explosive growth alternate with recessions. And no matter what specific news is, the general picture of the stock market sometimes fits the framework of a declining channel. As the “trend is your friend”, short positions will be preferable in this case.
Trading against market sentiment
If you monitor the market sentiment using the indicators of the clients’ positions of the brokers, you may notice that the majority are overly optimistic when the markets peak. Upon determining such a moment, you have a reason to open a short position.
Trading Signals
Trading signals are recommendations for opening a position, which are sent (for free or for a fee) by different providers – private traders, companies, financial consultants. Every popular stock at the U.S. exchanges has its own rating. If the analysts recommend SELLING, it is a reason to open a short position.
Trading correlated assets
Let’s say you know that exchange metals – silver, gold and platinum, are correlated to a degree. If you can see 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 improving your chances to the final success.
Opening short positions for risk hedging (insurance of portfolio) deserves a separate article. We will address this issue below.
How to Short Currency in the Forex MarketLong vs Short position
We already know that:
-
Long means immediate purchase of an asset with the goal of selling it later at a high price.
-
Short means borrowing an asset and immediately selling it with the purpose of buying it back later and at a lower price, and then returning it to the creditor.
What are other differences and peculiarities?
Short positions are traditionally viewed as carrying higher risks
The prices for the exchange assets range from 0 to infinity (if you discount the cases of negative prices for oil futures in the midst of COVID-19 pandemic in spring 2020).
Therefore, if you are taking a long position, it means that:
-
Your loss is limited to the price at zero level
-
Your profit is unlimited (for example, the A class shares of Berkshire Hathaway Inc are traded at USD 400,000 per share).
In contrast, if you are taking a short position, it means that:
-
Your profit is limited to the price at zero level
-
Your loss is unlimited. If the price skyrockets, your account will be emptied. Your broker does have negative balance protection, right?
As an example, we will use the situation with GME stocks. In 2020, professional managers of hedge funds decided that it is a fundamentally weak stock and shorted it.
However, in 2023 a group of investors from Reddit agreed to buy stocks. The price soared and caused huge losses to the hedge funds.
This story even became a subject of lawsuits and there was a congressional hearing on the incident.
When discussing the short position, it is reasonable to mention such a condition as a short squeeze. What does it mean?
When a group of traders are 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 higher the force of the demand. This is how GME stocks managed to grow so rapidly despite the weakness of fundamental indicators.
Another well-known short squeeze happened in October 2008, when Volkswagen shares soared in price, as the traders tried to cover short positions on their stocks. As a result, the price hiked from around EUR 200 to EUR 1,000 within a month.
Why short positions are more common in Forex
The Forex market is unique not only because it is the largest and fully decentralized one (the market does not have a physical address and the trading is carried out electronically). Any position in the market can be viewed as a short in relation to one currency and long in respect to the other currency.
For example, you funded your account with the broker in euro. And you bought 1 USDJPY lot. The fact that you opened a long towards the dollar also means that your shorted JPY.
Can short positions be opened in all markets?
No. If we are talking about spot markets, financial markets, there may be restrictions. For example, not all brokers allow you to open shorts on stocks.
They calculate the risks and may refuse if:
The other example is cryptocurrency exchanges. On some spot platforms you will not be able to short Bitcoin, but only buy the coin and place it on your account to hold and then sell.
However, since Bitcoin price actively moves in both directions, there is a large number of traders willing to short it. To meet this demand, crypto exchanges introduced futures trading, derivatives tied to Bitcoin rate.
The futures are highly speculative, because they have several advantages:
-
You can use them to open short and long positions;
-
Futures trading is charged with low commissions;
-
Futures markets allow to trade with leverage;
-
Futures markets are rich in liquidity;
-
Some futures have longer trading sessions than base 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 subscribed to trading crypto signals. You receive the following message on Telegram:
This is the reason to open a short position in the cryptocurrency market – in this case the provider assumes that the price will turn downwards from the downline and will travel down by 10-20%.
Whether it will happen or not is a different question. In this case, however, you are acting as a speculator reaping benefits from trading based on technical analysis signals.
Hedging risks
Let’s assume you are an investor in stocks holding long positions, but you see that the stock markets are moving to correction. To calmly ‘sit out’ the correction, you open a short position on stock index futures. Decrease in the value of the portfolio is compensated by the profit from the short position and can even substantially improve your efficiency, if you successfully cover the short on minimum correction.
Short Selling in Forex
Let’s assume you are holding a position on USDCAD. This means that there are two factors influencing your position: strength/weakness of the US dollar + strength/weakness of the Canadian dollar.
If you think about it, you are always holding a long position on one currency and a short position on the other. So when it’s morning in North America and there is important news for each currency scheduled to come out on the economic calendar, you want the good news for one currency and bad news for the other.
Best trading platforms for shorting assets
As we’ve established in the previous section of this article, you need a brokerage account in order to start trading. If you don’t have an account with a broker, we recommend that you check out the list of reliable companies.
Webull
Webull is a popular low-cost broker established in 2017 and headquartered in New York. With Webull you can invest in stocks, ETFs, options and cryptocurrency, and, surely, open short positions. The minimum deposit is as low as $1.
Is Webull reliable? Yes, the broker is regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority (FINRA). The company is also a member of SIPC offering protection of investor accounts.
The conditions for opening short positions are determined by the margin rate. Margin rate usually ranges from 4% to 9% annual; it is the payment for using the borrowed stocks. These are very beneficial conditions. Margin rate differs depending on the chosen stock. You can learn more by contacting Webull customer support.
Interactive Brokers
Interactive Brokers has been in the market since 1978, and is currently offering access to 135 financial markets in 33 countries.
The broker holds the necessary licenses, with the company’s shares quoted at the exchange.
Short selling is allowed on a large number of instruments. The fee for using borrowed assets starts from 1.5% and varies depending on the amount, which makes the broker a good partner for short selling.
Conclusion
Short selling can be a risky yet potentially profitable trading strategy for experienced investors. It necessitates a well-honed understanding of market dynamics, adept timing, and a robust risk management framework. Overall, short selling provides an opportunity to earn money during bearish market trends, but it requires diligence, constant monitoring of positions, and a stomach for risk. Used prudently as part of a balanced portfolio, shorts can diversify investments and potentially boost returns. But like any trading technique, the imprudent use of shorts can also amplify losses if not managed well.
FAQs
Who can be involved in short selling?
Usually short selling is available to all broker’s clients, although there may be restrictions on some instruments.
Can a short position be opened on stocks without borrowing the stocks?
No, such practice (naked shorting) is illegal in the USA.
Is short selling a risky type of trading?
All transactions in the financial markets carry a risk. Short selling is not an exception. It carries slightly higher risks than long selling. However, if you follow a tested 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?
It depends on the broker’s conditions. Ask the broker’s customer support about the margin rate. Most likely it will vary depending on the markets, the size of the short position and other factors.
If I am borrowing assets, when do I need to return them?
You can take as long as you need. A short position may be forcefully closed if you no longer have the financial possibility to hold it. Or, if the broker borrowed the assets in question from a third party in order to lend them to you and the third party has requested that the assets be returned, the broker may close your position, if there is no other way to obtain the assets elsewhere.
Related Articles
Team that worked on the article
Chinmay Soni is a financial analyst with more than 5 years of experience in working with stocks, Forex, derivatives, and other assets. As a founder of a boutique research firm and an active researcher, he covers various industries and fields, providing insights backed by statistical data. He is also an educator in the field of finance and technology.
As an author for Traders Union, he contributes his deep analytical insights on various topics, taking into account various aspects.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.
Dr. BJ Johnson’s motto: It always seems impossible until it’s done. You can do it.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.