The Trading Bible Trading Guides How to Bet Against a Stock - Short Selling Explained
How to Bet Against a Stock - Short Selling Explained
By Stefano Treviso, Updated on: Apr 07 2023.
Betting against a stock and profiting when the price falls is possible thanks to a technique known as short selling, here’s how it works:
- Borrow the stock from your broker (this will have a cost based on how hard the stock is to borrow)
- Sell it immediately at the current market price
- Buy it again when the price is cheaper
- Return the borrowed stock
- After returning the borrowed stock if you bought it back cheaper than when you sold it then your profit is that price difference minus the associated costs.
This is the logic behind short selling and we’re sure that the moment you read these points there are thousands of questions flowing through your head such as:
- How can I find stocks to borrow?
- Who in his right mind would lend me stocks if they know that I’ll return them being worth less?
- What happens if instead of falling the stock price goes up?
All of this questions will make sense as we move on through our guide. What we explained is the basic notion of short selling, but in reality behind closed doors many different things could be happening depending on the broker and the assets that you’re trading with.
Table of Contents:
- How does short selling works?
- Benefits of short selling
- Risks of short selling
- Short selling a stock vs a stock CFD
- Example of Short Selling (Betting against a stock)
- Profitable Short Sell Trade Example
- Losing Short Sell Trade Example
- How to bet against the stock market
- What is a short squeeze?
- Conclusion
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How does short selling works?
Short selling means betting against a stock, the process involves several transactions, let’s take a look:
- Getting ahold of the shares you want to short (since you do not own them, you’re forced to put margin as collateral for the transaction, that’s why short selling always happens on margin trading)
- Selling the shares immediately at market price
- Buying the shares back hopefully at a cheaper price (this part is usually called buy to cover)
Now I want you to stop and think for second, if you read our guide on how stock prices are determined, then you know that every action taken on the financial markets has an impact on prices, right?
Well, what happens when short sellers are closing their trades? (When they’re buying to cover)
They drive the price of the stock up momentarily. That’s why you never see an uptrend or downtrend that looks like a straight line, stock prices always travel on zig-zags due to the constant pressure of price action.
In the chart above we can clearly see a downtrend, so this means that during that downtrend:
- Bullish traders are closing losing long positions manually or hitting their stop-loss orders and when bulls close long trades by selling, they push prices further down.
- Short sellers are closing positions in profits and that pushes prices up as all of them (regardless of them betting against the stock) now they need to repurchase them (buy to cover).
So we have a very complex market situation where participants are meeting and fuelling each others strategies, can you see it now?
- Right when the downtrend starts, short traders sell their shares to the optimistic bulls looking to buy more and keep the price going up.
- As the downtrend becomes stronger, short sellers keep adding to their positions more shorts causing the price to keep falling even further.
- The bull trader could possibly be selling his shares at a loss to the short trader looking to buy to cover.
This can go on up until prices reach a point where the trend reverses due to all shorts getting closed and bulls coming in with an optimistic view on the stock (maybe they believe the price got too cheap and it’s time to buy).
Benefits of short selling
- Being able to profit from falling prices, you no longer care in which direction the market moves as you know you can take advantage of both
- Trading on margin comes with advantages and disadvantages, but one of the points in favour is being able to open trades with a small capital (remember, just because you can go big, doesn’t means you should, you must understand first how to trade with leverage correctly).
Risks of short selling
- There’s no limit on how much you can lose. A stock’s price can go up forever and you could end up stuck in a short (if you’re not willing to close it) with a massive loss
- Short selling can be halted from major exchanges when circuit breakers are activated due to huge falls in prices, this is done to protect the markets from panic sell offs
Short selling a stock vs a stock CFD
When you’re trading real stocks, there’s an actual borrowing process happening behind the scenes from your broker to get you those shares from an available pool they have, then you need to execute a sell order and later a buy order to return the shares. There is real ownership of the asset in question (the stocks) when you short with real equity (stocks).
When you’re shorting with CFDs you’re not getting ahold of anything or even finding a stock to borrow, there’s no real asset involved. You’re just engaging in a contract between you and your broker to exchange the price difference as follows:
- If the price of the asset is lower than when you opened the contract, the broker will pay you the difference in your favour (your profit)
- If the price of the asset is higher than the moment when you opened the contract, you’ll pay the difference in favour of the broker (your loss)
Shorting with CFDs is extremely easy to engage on and highly accessible in comparison to doing so with real equity but as always, there are risks involved. It’s highly advisable to learn as much as you can about CFDs before trading them.
Example of Short Selling (Betting against a stock)
Below we’ll use an example of a leveraged short trade with real data and what would be the result if it went right or wrong (leaving out the cost of borrowing if it was real equity or spread and commissions from CFDs).
Profitable Short Sell Trade Example
- Leverage: 1:10
- Quantity of shares: 100
- Opening price: $134
The first thing we know is that 100 shares multiplied by $134 each equals to $13.400 in trade value, then the trade value divided by the leverage factor (10) equals to $1.340, which is our required margin to open this short sell trade.
The green flag marks the start of the trade and the red flag marks the end which is the moment where the short sellers buys to cover.
In this example we started our short sell at $134 and bought to cover at $106.
To calculate our profit we take our starting price and we subtract the buy to cover price ($134 - $106 = $28) and then we must multiply the result ($28) by the quantity of shares we shorted (100).
The profit for this trade was $2800.
Losing Short Sell Trade Example
- Leverage: 1:10
- Quantity of shares: 100
- Opening price: $192
The first thing we know is that 100 Tesla shares multiplied by $192 each equals to $19.200 in trade value, then the trade value divided by the leverage factor (10) equals to $1.920, which is our required margin to open this short sell trade.
The green flag marks the start of the trade and the red flag marks the end which is the moment where the short sellers buys to cover.
In this example we started our short sell at $192 and bought to cover at $492.
To calculate our loss we take our starting price and we subtract the buy to cover price ($192 - $492 = -$300) and then we must multiply the result (-$300) by the quantity of shares we shorted (100).
The loss for this trade was -$30.000.
How to bet against the stock market
Now that we’ve fully understood the process to go short on an individual stock, what about short selling all the stock market?
Thanks to financial instruments such as Index futures , ETFs or CFDs based on any of the previous two, you can short a great portion of the U.S stock market for example.
Shorting process is the same according to the asset class, what matters is what your goals are, for example:
- Shorting the S&P500 (regardless of which financial instrument you use) means betting against a large portion the U.S stock market, the top 500 companies by market capitalization.
- Shorting an ETF known as XLK means betting against a considerable portion of large-cap tech companies.
You get the idea, constructing a short against a large group simply requires that you study carefully what are you targeting and why, so know the question becomes: which assets do you want to short?
What is a short squeeze?
A short squeeze happens when short sellers are aggressively betting agains a stock and fail at pushing the prices down, the asset’s price continues to climb and this forces short sellers to buy to cover at a loss. That same action of buying to cover at a higher price combined with a huge bullish pressure ends up fuelling a massive price increase.
A Short squeeze can also be called a bear squeeze, that is because in stock market jargon, bulls are the ones betting in favour of a stock’s price rising and bears are the ones betting against the stock’s price hoping that it falls.
The image above is a good example of how a short squeeze could have happened if short sellers opened their trades at the green dot and then prices continued to climb forcing them to close their trades at a loss (buy to cover) causing prices climb even further.
Conclusion
Short selling opens a whole new world of trading opportunities. We’re used to only profiting from upward price movements with the buy cheap sell expensive philosophy. Now we can also bet against stocks and several other assets, the real question now becomes: when to do so?
Disclaimer: what I’m about to say will sound incredibly horrible, bear in mind I’m just saying it for the sake of good trading.
Every single negative event in the world can become a trading opportunity, for example:
- A Boeing plane crashes leaving 300 people dead - That’s a shorting opportunity against BA (Boeing’s stock).
- A pharmaceutical company produces a vaccine, distributes it and new studies come out revealing that it can kill 40% of the people who take it - That’s a shorting opportunity against the pharmaceutical company’s stock.
- The CEO of a company goes to jail for embezzling funds - That’s a shorting opportunity against that company’s stock.
- A stock becomes the centre of attention and despite the company having a bad quality product with no possibility of true success in the future, everyone begins to buy the stock without any logic driving the prices up - That’s a shorting opportunity against an overpriced stock.
Got the idea?
You can now profit from horrible events all around the world and yes, I know it sounds bad, but, you’re not here to get spiritual lessons from me, you’re here to learn about trading.
Bear in mind that shorting carries unlimited risk as there’s no limit to how much can a stock’s price climb so if you’re caught on a short when a stock goes through a bull run, either you get squeezed or you hold a losing trade until you go broke.
Hope you liked our short selling guide.