We are going to go over a common trading term that you will hear often as a trader. Shorting or selling a security means that the trader is betting against the asset. This means that they want the asset to go down in value to make a profit. Going short has received bad stigma from the media; however, there are two reasons that someone would want to short a market.
They Believe the Asset Will Lose Value
Someone who is a short seller finds assets that are overpriced. They go short to make money off an overbought market or assets that are garbage. Sometimes they choose single assets such as a company that is under-performing. This could be a company that is in a bad financial position. Other times they are trading with the bear market trend. This could mean that the market overall is in a down-word trend.
They Are Hedging Another Position
This means that the trader has a long position in the market and takes the opposite position as a safety net. Think of hedging like an insurance policy. You are protecting yourself against the market turning against you. One way that a stock trader might do this is to go long on a stock and hedge their position using a derivative.
A Short Sale In The Stock Market
A traditional short sale in the stock market is something that most people don’t understand. I will go over this step by step to help you understand what is actually happening. When someone wants to short a stock, they are borrowing stock from their broker to sell. Let’s say like you have an account with Charles Swab and found a stock that you would like to short. Your broker would need to have another client that owns the stock for you to take a short position. This means not every stock is available for you to short.
What Actually Happens
A short sale means that you are borrowing someone else’s stock and selling it at the current market price. When the trader wants to close the position, they buy stock at the current market value as a replacement for the previously sold stock. This is the simplest definition of what it means to take a short position. In a nutshell, you are selling the stock to replace it with stock at a cheaper price.
As you might be thinking there is a few risks that goes along with this strategy. First, the stock can increase in value indefinitely. This means you can lose more money than your original investment. The next risk is dividend payments. In some cases the short will be liable for dividends that a stock pays to their owners. Last, there is a risk that you will be forced to close the position. You don’t own the asset. Someone else does, so it is their stock to sell. You are only borrowing shares in a short position.
There is another important concept that you will want to understand if you are going to short stock. At the bottom of most charts, there is a volume figure. The Volume is the amount of times a stock changes hands in a day. A short squeeze happens when short sellers where wrong and are scrambling to close their position. A famous short squeeze happened when traders bet against Netflix. People where betting against this stock when it was at $20. As some of you remember, Netflix came out with good news and has continued to go up in value. What took place is Netflix had too many buyers all at once and traders where scrambling to get out of there short position.
Shorting the Forex Market
In the Forex market selling a currency is different than shorting a stock. In the Forex market there are currency pairs. We have made a list of the traded currency pairs. In the Forex market, you are always buying while simultaneously selling a currency pair. In this position, the trader thinks that the value of the base currency is going to lose value.
With derivatives when you make a short sale this means that you take the opposite side of a contract. If we use stock options as an example, this means that there is a call side of the contract and a put side of the contract. The call side means that the trader is going long (wanting the stock to increase). The put side of the contract means that the seller is going short on the position (wanting the stock value to decrease).
Shorting Assets Using Derivatives
Using a stock option is a way for traders to go short on an investment with less risk. With traditional short selling, you could get screwed! With a stock option, you can only loose the premium that you pay to own the contract. This means you won’t loose more than you paid for the contract. Another benefit is that these contracts are more leveraged. Each contract is less money than buying or selling the stock outright. This means you can either get more contracts for your money or reduce the risk by taking a smaller position.
Using Puts As Insurance
Some people use puts as a way to reduce portfolio risk. This means that they take a put contract on a position that they already own. This can be describe as reducing market risk. There are so many strategy that someone can do, that we will write a page on this and link it here.