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Shorting strategies that work – All the trading practices you need to know in 2019

Short selling is a common practice in stock trading. Simply put, short selling is selling an asset or stock that the seller does not own. Most day trading guides provide a detailed explanation of this practice, but the main thing to understand is this: in a short selling transaction, a seller sells securities or stocks that he has borrowed in anticipation of a price decline and is then required to return an equal number of shares at a future date.

  • Short selling basics
  • Shorting strategies for beginners
  • Who are the typical short sellers?
  • The three best shorting strategies
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Short selling basics – is short selling ethical?

As mentioned above, short selling refers to the sale of any financial instrument – such as a stock or financial security – without owning it. The seller borrows a stock in anticipation of a price decline, which would let him buy more of that stock in the future. Eventually, he sells the stock and ends up with a profit in the form of surplus shares after returning the borrowed shares. The price at which the securities were sold short and the price at which the securities are purchased later is the short seller’s profit. If done properly and correctly, short selling can reap desirable results.

There is often a question of whether short selling is ethical in the stock trading business. The reality is that short selling is one of the most misunderstood trading strategies you can find. There is a common misconception that short sellers are looking for quick, short-term gains without any regard for the losses that companies are suffering leading to a fall in their share prices. In fact, the short sellers keep markets liquid and ensure regular financial trading.

Traders should keep in mind that shorting strategies are quite risky, primarily because the whole concept of shorting goes against the long-term upward trend in the market. However, short selling can protect investors against financial fraud by exposing companies that deceptively project a better image of their performance to escalate their share prices.

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Short selling strategies for beginners – how to short sell

To make it clear, a short sale is a transaction that involves a seller selling stocks that he actually does not own. The seller borrows the stocks or shares to trade on them because he anticipates that the price of the stocks will decline at a future date. While the seller has the obligation to return back the borrowed shares, the probably decline in price will allow the short seller to buy back the shares at a lower price than what he sold them at, thus making his profit.

  • The short sales are known as margin transactions.
  • Their equity reserve requirements are more stringent.
  • The seller borrows shares as part of the shorting strategies from custody banks and fund management companies.
  • The main advantage of shorting is that it allows the traders to make a profit from the drop in price in the shares.
  • Short sellers aim to sell their shares when the price is high and buy them back when the price declines as they have anticipated.
  • Short sales are considered as risky as the price of the shares may increase rather than decrease as the short seller had thought.

Most experienced short sellers offset their risk by using a stop-loss order that immediately sells the stocks when the prices begin to rise so that there is a minimum trading loss to the short seller.

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Margin accounts and what to short sell

To get started with short selling, you need to sign up for a margin account with a brokerage firm. A quick broker comparison will help you choose the ideal broker. This account requires you to deposit a certain amount, known as a margin, before you start shorting. A standard rule is to deposit a margin of 150% of your share’s shorting value. After opening a margin account, you need to start looking for potential shares or stocks, the price of which you believe will decline.

Here is how you can begin short selling:

  • Once you have identified a stock that you would like to short sell, you need to place an order through a brokerage account or a financial advisor. Make sure to mention that the stocks would be short sold. Otherwise, it would be in violation of securities laws.
  • After you place the order, your broker will borrow the shares in the quantity you have ordered from multiple sources. The broker must ensure that security can be borrowed and will be available to the short seller on the date the delivery is due, as any delay can cause the short sellers huge losses. This is known as ‘locate’ requirement.
  • Once the shares have been borrowed, they will be sold in the market. The proceeds from the sale are then deposited into the margin account of the short seller.

Based on whether the price of the stock declines or increases, the shorting can result in a profit or loss.

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Who are the typical short sellers?

When talking about shorting, there is one thing that is certain – not every trader in the market can expect to implement this particular trading strategy. While short selling can be very beneficial to those who have a keen eye for the market, for others it will involve unnecessary risk and stress. For example, investors who have just started trading are likely to find short selling too overwhelming to work into their routine. These transactions are time sensitive and require fast action. Following is a list of the most common short sellers to be found in any trading market:

  • Hedge funds are the common short sellers in the market who try to hedge the market risk by selling stocks short that they believe are overvalued.
  • Experienced investors also short sell, sometimes to hedge the market and sometimes by following their own calculated speculation.
  • Day traders are the other key players in short selling. Many short-term day traders are looking for temporary and small financial gains, so they may find shorting to be a suitable trading strategy.

Having said that, anyone can become involved in short selling, as long as they are aware of the potential risks and have measures in place to mitigate those risks.

Risks associated with shorting

Shorting involves a number of risks. These include the following:

  • There can be a skewed risk/reward payoff. In long-term trading in stock markets or securities, losses are limited to the amount invested in the shares. This doesn’t apply with short selling. Instead, the loss is manifold as the speculation of a price drop can reverse significantly, leading to a great loss for the short seller.
  • Shorting can turn out to be more expensive than originally thought. In some cases, the costs can be more than the commissions. There is interest payable on the margin account for the borrowed shares. The short seller is supposed to make the dividend payments on the stocks that have been shorted. So unless you are confident that prices will decline, shorting can be very risky.
  • With shorting, timing is the most significant element. Poor timing can have a negative impact on potential profits.
  • There are certain regulatory risks. Some market regulators tend to occasionally impose bans on short-selling based on market conditions. Shorts that are heavily shorted stand the risk of buy-in by the company. This can be a big risk for the short seller who could end up with heavy losses.

Shorting also requires strict trading discipline. The number of risks associated with shorting means that the traders must be very disciplined in their trading strategies. Short selling requires the seller to be constantly up-to-date with the market conditions and act in a timely manner for maximum gain.

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Moving averages and their place in short selling strategies

There are various ways that short sellers can employ to find the right opportunities for short sale. Traders who use technical analysis to find short selling opportunities often find it easier to offset the risk and make financial gains. Detailed below are two shorting strategies that are based on the use of technical analysis on the stocks and the market so that the risk is limited and the speculation is more practical.

  • The stock is falling below its 50-day moving average.

Moving averages are very important to identify the trading value of a particular stock. Traders who base their short selling strategies on technical analysis will find it easier to strategize the moving averages to work in their favour. If a particular stock is getting close to breaking back above its 50-day moving average and above the gap down highs but cannot make that happen, it could be a trigger for a price decline.

  • The stock is falling below its 200-day moving average.

As mentioned above, moving averages provide a very clear perspective to short sellers when it comes to identifying the right time for their short sale. With the 200 day moving average, it gets even easier due to the lack of extensive price volatility. The stocks that are coming out of long-term run and are moving towards a decline can be easily identified using this data. Short sellers can take this as an opportunity to short sale the stock.

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Observing that a stock is experiencing fresh lows

Another thing to look out for when evaluating your opportunities for shorts is a situation in which a stock is trading to fresh lows. By paying close attention and identifying that the stocks had a big gap down day followed by a day of fresh lows, you may be able to speculate further decline. At this point, it could be wise to go ahead with a short sale. Deciding when this applies will become easier the more you observe. In some instances, this strategy does not pay off and it pays to have

Moving averages along with proper interpretation of the volumes can be one of the easiest forms of technical analysis for traders who have the right experience. This way, you can look for short points or even buy points for short selling. A more sophisticated trader may use MACD and RSI to identify shorting points more accurately. However, there is one thing to keep in mind here. It is important to make sure to cover short sale positions with stop orders that act as insurance. As there is always a possibility of the upside trend on the short sale stock, the stop order can control the extent of any possible losses significantly.

Conclusion:

Conclusion

Now that we have covered what short selling is and the many strategies that can be employed to utilise it, you may have a better idea of who should employ this approach. It is important to note that shorting is a very advanced trading strategy that is most suitable for experienced traders with a thorough understanding of market and stock trends. It is essential that short sellers are traders who are well aware of the risks associated with shorting as well as the various regulations in place. An average investor dealing in short selling should use put options to hedge the downside risk or have the ability to anticipate a decline with limited risk involved. That is why research and education are key before diving in. For those who understand the market trends effectively, shorting strategies can become a great tool for getting the most out of their investment game.

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