Short Selling: How, When and Why You Should Short Sell

Short Selling

What is “short selling” and how does it work?

The concept of short selling is often seen as something immoral or alarming to many traders. Traders often assume that because mutual funds and financial planners go long, it is more correct to do. When you short sell you are actually borrowing a stock at a fee, and selling it on the market. At some point the trader “covers” his sale by repurchasing the stock at the current market price, and returning the shares to the lender. If the price is lower the short seller makes a profit, else he makes a loss.

algo trading

Why are people scared to short sell?

I believe this phenomenon arises for the bombardment of interested parties in keeping traders constantly bullish. The people who are long and pay for the advertising on financial websites have a good reason to do so. Company management is naturally biased as they generally own stocks; it is their end goal to increase value for shareholders. The financial press is mostly financed by advertising through mutual funds, financial managers and brokers. All three have one thing in common, the more bullish the market is, the more capital is invested in their respective institutions which means they make more money. If markets are bad, less people trade and all big institutions lose out when the market has a negative cash-flow.

Governments which should be unbiased of course are. For one, they are interested in a bullish market, the most powerful lobbyists and firms are financing them are breathing down their necks. They have every reason to be heavily biased towards a bullish market. Likewise, rating firms are paid by the companies and bankers which they rate – which makes them far more inclined to raise their rating rather than lower it.  These companies need to have their bonds rated, and they will naturally lean towards the friendliest rating agency.

So why are people scared to short? Because this goes against what the big players want you to do. By going short you take advantage of all the over pumped bullish news. Sell side analysts will often associate false information and market manipulation with short sellers, but this sword swings both directions. The fact is there is no good or bad, only those who make money and those who lose money.

Ironically, short sellers who make money actually benefit the market and those who lose make it worse. By short selling towards peaks, short sellers pressure prices down thus preventing the share from being significantly overvalued. When the price reverses and reaches the trough (bottom), short sellers will cover their position by buying the shares and preventing the security from being significantly undervalued. By lowering the volatility even the long term value traders benefit from the short seller.

So who are biggest losers? It is the short-term swing traders who go long only and are simply missing a huge asset in their toolbox.

How to get started on short selling?

Open a paper trading account with a broker such as think or swim to get a feel beforehand. Due to T-regulation you will need a margin account to short sell, with at least 150% of your trade value in equity to cover liability. Theoretically you can lose more than you invested, because the potential upside movement of the stock could be more than 100%.

Next you will realize that some stocks are not available to short sell, familiarize yourself with those who are. From here you must decide what you want to trade, which is easy with a tool such as I Know First (elaborated below). Once you are set up you should now have the option to sell the stock, even if you do not currently own it. Pick a stock and set a limit order at the highest possible bid (remember you are the seller!), and try to cover (buy back) at the lowest price point. Furthermore, to manage risk you can set a stop loss at above the current price level.

short sellingAlgorithmic Strategy: How to decide which stocks to short?

I Know First’s interface macro is a great new tool for deciding on your trade positions. The algorithm successfully predicts stock trends over time, and on July 9th this was the prediction of our Top Stocks universe. Now those who invested and held mostly did pretty well for themselves; however, their prediction was sharply contradicting the current market trend.

All the annual subscribers who use the interface macro would quickly see that almost no long predictions were currently trending up. In contrast, almost all short-sell recommendations were plummeting in price.

This made it interesting to go short; unfortunately most brokers do not support short sales on low liquidity stocks. Ideally GSH would have been the best option; however as it was unavailable to immediately short sell some compromises had to be made. In the end the strongest negative signals available were:

WFT (-100.93) – Weatherford International plc – NYSE

ALU (-81.04) – Alcatel-Lucent

AA (-75.36) – Alcoa Inc

short selling

One should set limit orders which are above the average size. With such volatile markets it makes a lot of sense to take maximum advantage. It is better to never have your order filled than to lose on the spread.

Now that I had all my orders filled at a price I was happy with I decided to stick with the algorithmic prediction and hold. While prices dropped nicely for AA and WTF by -8.74% and -12.33% respectively, ALU increased by 3.75% in the three week horizon. The decision to sell is clear by the 28th of July, as all the 3 day forecasts for these stocks become bullish again – indicating they have dropped below their equilibrium price level.

short selling

The forecast did materialize nicely; however, it took patience and confidence. The drop in price was not clean or straight, with slight losses and high volatility throughout.  What is even more astonishing is that the S&P500 actually rose 3% during that period, while our short sales returned a decent profit!

Below is the final standing before liquidation and closing orders.
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