Day Traders Looking to Get Involved in Potentially Short Selling
When trying to become a complete trader, there is nothing more essential than short selling.
Due to mandates, in many cases money managers are unable to short sell due to rules put in place by trading regulators.
There are many traders who never sell their trades due to the fears of creating any sense of risk that may be involved for themselves or their business. Warren Buffet being an example of this. However, some people don’t ever short sell as they go along the lines that earning money through shorting is harder. In essence, people will go along the lines of buying assets as there is an unspoken ideology that in the long-term, they will eventually become worth more than any cash return that one could get.
That is why if you’re short risk premia it may seem difficult to earn money as the long-term financial asset markets tend to rise often.
An example of this would be the following:
Where will Apple stock be 10 years from now? Probably higher. At what stage will Apple’s stock be in a decade? Most likely higher than it is now.
So, if you were to invest in American companies such as Apple then there is a massive chance that you will have made money over the next decade purely just by holding onto that asset for the decade.
The Functions of Short Selling
In short, short selling essentially is the process of a buyer loaning an asset that they do not actually own the rights to and then proceeds to sell it on the market at a given time. Whenever the position for the short is closed, then the person who sold it will have to rebuy the asset on the market this time and send it to the initial lender to relinquish the original amount that they had loaned in order to get access to the asset in the first place.
When getting involved with an easy to borrow share, the general interest per annum on the loan is around 1-2%, similarly to a bank in a way. However, when getting involved with hard to borrow shares, that interest fee can often be so high that the option of short selling is not even an option for people who cannot afford it.
There can also be something involved called positive carry. This is when the base currency involved obtains overnight interest rates that are higher than the original cost of short selling, then this is what will create a positive carry for the trader.
Where Is Short Selling Most Common?
When short selling you’ll probably notice that short selling occurs most often in stock markets, currency and future trading.
Just as an example, if you were to set out on shorting the EUR to USD then that would essentially mean you would be lending euros to purchase dollars. If you were to then shut the position, you would be buying back the euros and selling the dollars as a result. This will either result in a profit or loss depending on values existing when the position is closed.
If you are trying to gain some early interest in short selling, most traders will start by viewing the short interest ratio. This basically takes the number of shares and will divide them by the total share count. This usually results in a number below 10%, however if the stock is going through financial issues, then this number could easily be higher than 10%.
The Risks Involved with Short Selling
There is always an element of risk when buying, that risk could be you potentially losing all of your asset value. But when you short sell your asset then this is when the asset risk theoretically becomes unlimited. However, this may be worth noting that this can result in you owing more than you initial spent depending on your net profit or lose.
The Ethics of Short Selling
When having a share in a company, that usually means that you own stocks in that specific company, if the values of your stocks were to rise, then that means the business is bettering itself.
However, short sellers are often in the line of fire for abuse as they hope businesses fail as it will result in them having the businesses price drop so low that it allows them as traders to create a scenario where they can turn a profit. Despite all the abuse that short sellers get, it is something that is vital in the functioning of the financial market. It helps ensure that price discovery is consistently balanced.
As well as this, it is often the case that short sellers will discover ay fraud or illegal acts taking place within companies rather than regulators also, once again proving they have a place in the market.
Short selling can often be something that is shamed in currency markets. Especially when short selling a nations national currency, it can be seen as an act of defiance or treachery against your own nation in a way in some countries. However, in the situation where short sellers are correct then they are simply using their skills to highlight lacking areas of the market rather than turning against their own nation.
Other Options of Short Selling
Short selling can also be done through futures contracts or swaps, as well as involving instruments.
Overview of Short Selling Strategies
Outright Short (Unhedged)
An outright bet is how some short selling can be seen as when the decline of an asset begins. This is so much so the case that some markets even decide to short an asset themselves.
An example of this can be seen below:
In November 2018, any US treasury bonds were massively and accordingly shorted. The image below shows this.
The first alternate angle this idea can be viewed from is the US Federal Reserve manually increasing interest rates.
As well as this, the Fed is manually tapering its balance sheet of assets that had gathered following the devastation of the market in 2008.
If you were to put this in the simplest of terms, if the supply is more than the demand, then the price of the supply will subsequently fall as a result.
If the price then falls at the site of a lack of demand, this is the chance for traders to pounce and make use of the low prices before they begin to rise again.
The majority of hedge funds are a mixture of 150% long and 85% when short.
Some traders may go the short route to avoid any hedge risk from a potential factor of a market that they not want to be within the vision of to have it affect them.
A trader may not want to be associated or affected by momentum.
A trader may also not want to be affected by the US dollar. Hedging out could occur here by choosing the long option here and deciphering yourself how much would be required to be hedged along with the fluctuation of the currency you’re trading.
Any oil companies, farmer and that of the such will be leaning towards assets that are tied in with the successes of their businesses’ work.
Protecting Yourself Against the Risks of Short Selling
To protect themselves when short selling, traders will often use stop-loss. This essentially has a number of benefits but is mainly used to prevent huge losses or any potential losses down the line.
Short squeeze is also a term that short sellers should swiftly become familiar with. If a short seller has a position that is big enough then the chance to lose their total value is on the horizon, meaning you as the trader will be required to have a plan in place to limit your losses.
Short squeezing is something that usually speeds up the increase of an assets base price. A short squeeze involves the buying of shares and often causes an acceleration in the rise of an asset’s price.
When trying to avoid short squeezes, it is important to keep a keen eye on your position size. If a position is opposing you, then you have gone too large and a short squeeze is something that may be coming.
In conclusion, short sellers and short sellers are something that is of vital importance to the market. Despite the never-ending arguments regarding the ethics of short selling, there is little proof that hindering short selling actually improves the general market’s efficiency.
When looking to control an unlimited risk that is involved within short selling there is a number of ways to do it, here are a few just to name them:
- Making use of a stop-loss system.
- Do not go to large, this is key to avoiding short squeeze.
- Keep away from illiquid market.