All in good time. When the best time to sell short?
10:35, 5 March 2022
In the equities markets, one can make a profit without owning any securities. Sounds puzzling? And it can be, but mainly for novice traders. Well-seasoned investors know how to capitalise on the equities they don’t possess. As well as on those dropping in value. This is possible through the strategy of short selling
Overall, an investor earns or loses the difference between the price at which they sold a security and the price at which they bought it.
Prices rise and fall, and both scenarios can potentially be profitable. Not to miss on extra opportunities, traders go short on markets in decline. Short selling creates additional conditions to capitalise on. Meanwhile, it comes off as a more complicated alternative to going long. Short selling is in no way more sophisticated than buy-and-hold strategy.
Let’s take CFDs, which are financial derivative products that can be used for both going long and short. To open a position in either of the directions, you need to choose a potentially profitable instrument first. Once you’ve identified a market in decline, you choose ‘Sell’ and open a short position. As simple as that! And you don’t have to purchase the instrument in the first place.
Let's see how profit or loss is calculated for a short sale trade. For the sake of simplicity, the examples below don’t take into account commissions or fees.
Example 1. The winning scenario
- You borrow and short 100 shares of company CPL at £30 per share
- The CPL stock price falls to £20
- You buy back 100 CPL shares at £20. The total profit is (£30 - £20) x 100 shares = £1,000
Example 2. The losing scenario
- You borrow and short 100 shares of company CPL at £30 per share
- The CPL stock price rises to £40
- You have to buy back 100 CPL shares at £40. The total loss is (£30 - £40) x 100 shares = - £1,000
In the first situation, a trader will profit until the stock decreases. Sure, it’s value cannot drop below zero, but can, in theory, grow infinitely. In short selling, the losses are unlimited while gains are not. In long positions, the scenario is quite the opposite.
Short sale timing
As a rule, stocks fall in value more rapidly than they grow. This may eat up all the profits. That is why timing is vital for a successful short sale. If you go short too early, you may have to wait quite a long time before the value drops and incur considerable costs doing so. On the other hand, missing the moment can wipe out the majority of the profits.
Here are some ideas for timely short selling.
When the market is bearish
Short selling is the most fruitful when the market declines precipitously and sharply. The global crisis of 2008–2009 was quite the time. Short sellers made fat profits on big financial landslides.
Downward trends reign supreme in a bear market. Trend trader can capitalise on such an environment by short selling, while the bullish scenario is better for going long.
When the market isn’t ‘dull’
A common trading rule says: “Never short a dull market”. The market is dull, or flat, when there’s hardly any action or change there and when trading volume is low. It is believed that an inert market is accumulating energy before a dramatic rise.
Moreover, don’t go short during options expiration week or the holidays, because the correct supply/demand balance is shifted.
When fundamentals are worsening
Macro- and microeconomic fundamentals can go weak. For the overall economy and its smaller segments, deteriorating data can indicate a potential economic slowdown, bearish market sentiments or new volume lows, etc.
Stock fundamentals can weaken as well. The reasons are multiple, from dropping revenue, to growing input costs, to bigger challenges a company faces.
However, seasoned short sellers will never hurry up to take action. Before going short, they will wait until the bearish trend consolidates.
When the investment is priced for perfection
Efficient market theory implies that the price immediately reflects positive predictions, including innovations, strong earnings, product launches, etc. Stocks whose value already includes positive developments are called ‘priced for perfection’. The thing is that such stocks may not grow when good news is actually released, as the improvements have already been predicted.
Once investors realise they’ve been over-optimistic, the downward phase begins. This is the best time for a short seller to kick start their investment strategy.
Conclusion
Entering a short sale timely is crucial. The best moment is when the above-mentioned factors come together. Typically, this moment coincides with the early phases of a bearish market.
Short selling as well as long positions can bring losses if you don’t take risk management measures. Stop loss is one of them. You specify a price level at which you want to close your position when the price moves against you.
Mind that a basic stop order doesn’t secure your position completely. Sometimes, prices slippage occurs, and your order is executed at a less favourable price. For an efficient protection, place guaranteed stop loss, which excludes the possibility of price breaches. However, a guaranteed stop order is available for additional fee.
To learn how short selling can work for your trading strategy watch our video: