Most investors are familiar with purchasing an asset and benefiting from the price or exchange rate increasing or declining, generating gains or losses. If you want to bet that prices will fall, there is another technique called short selling which allows investors to profit if an asset decreases in value. Theoretically, the concept behind short selling involves borrowing a security from a broker and selling it on the open market, expecting the price or exchange rate to decline. The investor then buys back the investment at a lower price and returns it to the broker, pocketing the difference.
Short selling offers investors the opportunity to alter their trading strategy to benefit from a price rising and profit when prices fall. This trading strategy also opens the door for a pair or market-neutral trading strategy. Short selling can work with several types of assets, providing investors with opportunities to gain when assets become overvalued. Investors can also hedge their downside exposure to an investment by short-selling other securities.
What is Short Selling?
Short selling is a trading technique where an investor sells assets, hoping the price will decline and allowing the investors to repurchase the asset at a lower price. The process of short-selling an asset starts by borrowing securities from a broker and then selling the borrowed asset. You profit from short selling when the shares you borrow decline in value, allowing you to repurchase them at a lower level.
There are two types of short positions. There is the naked short position, where you sell a security without owning the asset, and there is a covered short, when you borrow the securities and own them and then generate a short position. The former is considered illegal in the United States.
The practice of short selling and shorting futures or CFD are similar, but the method is different.
If you short a futures contract or a contract for differences, you sell an asset within a margin account. Your broker will allow you to use margin and require sufficient equity in your futures or CFD account to cover any losses you might incur. You do not need to borrow the security when you short a futures contract or a CFD within a margin account.
What are the Risks of Short Selling an Investment?
Shorting an asset can be a risky endeavor. One of the reasons is that your losses can be unlimited. Most assets purchased are bound by zero, so the most you can lose if you purchase an investment is that it falls to zero. When you short an asset, your losses can be unlimited since there is no price that an asset can climb to that is bound.
When you short-sell stock in the United States, the amount of equity you need to post is larger than the margin required when you purchase a stock. According to Regulation T, an investor must have 150% of the short sale value when the short sale is initiated. The amount is the total value of the stock plus an additional 50% of the value to incorporate the unlimited nature of the loss that can be generated from a short sale. Margin requirements for futures and CFD trading are different.
What is a Margin Account?
To short an asset, you need to open a margin account. A margin account is a brokerage account in which the broker lends the customer cash to purchase securities. The securities and cash collateralize money used to create the short position. The margin account can buy stocks, bonds, forex, options, CFDs, futures, and other investments. Margin accounts allow investors to buy more securities than they could with just the cash in their account.
There are generally two different types of margins required. The first initial margin. The initial margin is the amount of money that must be deposited in a margin account before trading on margin or selling short. The minimum amount of equity must be maintained in the account as collateral in case of losses.
The maintenance margin is the minimum amount of equity that must be maintained in a margin account. The amount of equity must be held to keep the account open and avoid a margin call. Futures or CFD brokers will set the maintenance margin. They will use calculations to ensure you have enough equity in your account to cover potential losses. Your broker will not take losses for you and generally will have you sign an agreement that says that if you do not have enough money in your account to cover potential losses, they have the right to sell you open positions.
Before your broker sells your open positions to use the capital to cover a potential loss, they will issue a margin call. A margin call is a demand from a broker or other financial institution that an investor deposit additional money or securities into their margin account. This scenario is typically done when the account value exceeds the broker’s minimum value. A margin call is a warning that the investor’s account is in danger of being liquidated or closed if the investor does not take action.
What Types of Strategies Can Be Used When You Short an Asset?
Once you set up your margin account, you can short an asset and use several strategies that can benefit if the price or exchange rate declines. You might believe that the price of an asset to elevated and might correct, or you might believe that the price of an investment is high relative to other assets.
One common strategy that involves short selling is a market-neutral trading strategy. A market-neutral trading strategy is an investment strategy that seeks to generate returns that are not correlated to the overall performance of the stock market. This scenario is achieved by taking long and short positions in the same or similar securities to profit from the price discrepancies between the two positions. Hedge funds and other institutional investors often use this strategy to reduce their overall market risk. One of the most common is called a pair trade.
A pair trade is an investment strategy that involves simultaneously buying one security and selling another related security. A pair trade aims to capitalize on the relative performance of two securities, with the expectation that the long position will outperform the short position.
Another way that a short position can assist a trader is through hedging. Hedging is a risk management strategy used to reduce or offset the chance of loss from fluctuations in the prices of commodities, currencies, or securities. It involves taking an offsetting position in a related security, such as a futures contract, CFD, or index. Hedging protects against price volatility and reduces the risk of loss from an adverse price movement. Investors who believe that an event will occur that will negatively impact their position will often hedge their exposure to reduce a negative move in the value of the asset they own.
Using Technical Analysis
One of the most common ways that an investor can generate a strategy to short an asset is to use technical analysis. The technical study evaluates securities by analyzing the historical prices.
For example, when a price of an asset is overbought, you might consider shorting the price looking for it to decline. One technical analysis method that can be used to determine if the price of an asset is overbought or oversold is the relative strength index. The Relative Strength Index (RSI) is a technical indicator used in the analysis of financial markets. It is intended to chart a stock or market’s current and historical strength or weakness based on the closing prices of a recent trading period. The RSI is classified as a momentum oscillator, measuring the velocity and magnitude of directional price movements.
The Bottom Line
The upshot is that short selling is a technique that can be used to broaden your trading strategies. Shorting is the process of speculating or hedging, where you benefit if the price of an asset declines. Short selling can be used in stocks, bonds, futures, forex, and CFDs. The process of shorting is different for each financial security. Each method requires a margin account.
You can use shorting an asset to hedge your exposure to long positions. You can also create a market-neutral position or a pair trade where you benefit from the outperformance of one investment relative to another asset. There is a multitude of strategies that can be accomplished and including the use of technical analysis to find assets that are overbought or overvalued.
