Understanding Short Selling And How To Take Make Money On A Falling Market

April 13, 2021
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Short selling has become a very popular tool across a multitude of markets. It essentially allows traders to take advantage of a market even when the market is falling in price. For most traders, money is there to be made when the price of the thing they are trading is going up, but the ability to short sell means there are a lot more chances to make money.

While making money from a market on the up is relatively simple — buying at a lower price and selling higher — short selling is a little more complicated. This can bring in a couple other advantages, and chances for profitability, but it also comes with a few risks. 

It is important to understand how short selling works in order to get the most out of it, but once you have the basics right, even if you think the price of your chosen asset is going to fall, you can position yourself for profits. 

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What Is Short Selling And how does it work?

On the face of it, short selling is a relatively easy concept to understand and it involves an investor borrowing stocks, then selling those stocks, and then buys the stock back to return it to the lender.

This works in the favour  of the investor because they are doing this with the idea that the price of the stock, crypto, asset, or commodity is going to dip down for some reason. In essence, if you borrow stocks that you have to return, but sell them straight away before a price dip, you get to buy the stocks back at a cheaper price to return the borrowed amount while also picking up profit along the way. 

Short sellers are betting that the stock they sell will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender. The difference between the sell price and the buy price is the profit.

Short selling example

To understand it in context: imagine if  an investor thinks that Tesla stock is trading too high at $525 per share. They think the price is due to fall, so in anticipation of this, the investor can borrow 100 shares of TSLA from a broker, and sell them straight away from the current market price of $525.

Then, If the stock drops to down to $400, the investor could buy the 10 shares back at the new lower price and return those shares that they borrowed. But, by doing this, they have also managed to net a profit of $12,500 ($52,250 – $40,000). 

However, if the TSLA price rises to $600, the investor would lose $7,500 ($52,500 – $60,000).

Advantages And Disadvantages Of Short Selling 

As mentioned, short selling is a popular way to make money when the market is falling, but it also holds a number of other advantages that new and experienced traders alike are able to take advantage of.

Advantages :

  • Profit on a falling market: The main reason that people like short selling is that it allows for trading on a stock, crypto, commodity or asset at all times. That is to say, in normal trading circles, there is usually only money to be made when the price of the asset is rising as a trader can buy low and sell high. When it comes to short selling, even if the price of the asset is falling, money can be made. 
  • Hedge your bets: tied into profiting on a falling market is this notion of being able to hedge your portfolio in both directions. For example, if you have a few short positions in a market, if there is a sudden collapse, or financial crisis, the majority of your portfolio will fall, but the short positions will mitigate some of those losses by making you money. 
  • Using volatility: In more volatile markets there are higher chances to make money as the price of a stock can rise quickly, and money can be made. But in short selling volatile markets, there is a way to make big money both ways and with the movements being big, it becomes slightly easier to follow the prices. 

Disadvantages:

  • Paying commission: It must be remembered that because you are essentially borrowing a stock / asset from a broker, there is a fee involved which means you are paying a commission depending on how long you hold your short position.
  • Drops to zero: While shortening is a way to make money from a falling market, a market that is falling too quickly, or with a lot of losses can be inherently dangerous. There have been times where stocks have gone to zero, leaving short sellers in a lot of trouble. 

How To Short Sell

Shorting, as a popular trading tool, has also become a relatively simple task. The amount of trading platforms that offer a seamless short selling trading experience are vast and their offerings are designed to make things easy. 

It is however first important to understand the two different ways in which a stock can be shorted; with a traditional brokerage or a leveraged trading provider.

In a traditional brokerage, traders borrow shares they do not own. These shares are usually lent from their financial broker. The trader then sells the borrowed shares at market value. The trader aims to repurchase the same shares at a lower price and return the shares to the lender. If the price of the stock drops, short-sellers profit from the difference in price between the rate they borrowed at, and the rate they repurchase the shares.

When traders short sell via leveraged trading, they do not own the underlying stocks. Spread betting and CFD trading are two types of leveraged trading with many similarities and some unique differences. However, both products offer the trader an opportunity to take a ‘sell’ position on shares and profit from stock price downfalls without the need to borrow physical stocks. 

Steps To Short Selling:

  • Open a trading account on a platform that offers the asset you are looking for
  • Choose the stock, asset, crypto or commodity that you think will soon fall in price
  • Manage your risk. Before you place a trade, make sure you have adhered to a suitable risk management strategy.
  • Go ‘short’ and sell. Choose a position size in line with your trading strategy and place a ‘sell’s order ticket request to short-sell your chosen stock.

Short Selling vs. Long Selling

While short selling is the notion of betting against a stock / asset and hoping its price will go down, it is pretty much the opposite from traditional trading where you hope for a price rise to sell at a better price, known as long selling.

Long selling is essentially just owning a stock and holding onto it until a time that the price is better than when it was first purchased. From here, if the stock is sold, the trader makes a profit. This profit is technically unlimited as a stock’s price can keep going up. 

For example, If you go long on 1,000 shares of a stock at $10, the transaction costs you $10,000. If you are able to sell the shares at $10.20, you will receive $10,200, and net a $200 profit, minus commissions. This is the desired result when going long. Learn more about Bitcoin Shorting

Short Selling Strategies 

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Of course, short selling is quite a strategic way to trade as it involves not only betting on a future event but also deciding on when to pull your position out depending on commissions rates and other considerations. 

Selling Pullback In A Downtrend

Many traders choose short sales when a stock or asset reaches a new high. They believe the price would have risen too far.A pullback is a price falling back to an original from a peak. This price movement is a brief reversal of an upward trend that signals a slight pause in upward momentum and provides a good chance for a quick short sell.

Incorporate Seasonality Into Trading

Short selling during option expiration weeks and around holidays can have painful loss consequences. These markets do not follow natural supply-and-demand and thus it is better to avoid these times and stick to shorting the market in normal trading times. Every market activity segment such as Monday’s opening bell and Friday’s closing reflect some time element bias. Results improve when traders incorporate the elements into their workflow.

Trade And Profit From Pattern Failure

Many traders buy breakouts and sell breakdowns. Others attempt to profit by doing the opposite. They wait for a sell-off or rally to fail and buy the breakdown or sell the breakout. The oppositional against-the-grain tactics take the concept a step further. They buy when failures fail. Modern algorithm programs anticipate how human traders react to breakout failure to attract momentum.

FAQ

What Is Meant By Short Selling?

Short selling is betting that the market will fall in the coming days and positioning yourself to profit from that. It involves borrowing stocks and selling them at a price, then when the price falls, buying back the stocks at a cheaper price to take the profit and return the borrowed assets.

Is It Worth Selling Short?

Short selling is a powerful strategy that allows for profiting even when a stock is in a downward trend. This makes short selling worth it as it can increase the time you can trade and offer more opportunities for profiting. 

What Is The Benefit Of Short Selling?

Short selling’s major benefit is the power it gives a trader to constantly trade a stock. If the price is going up, they can long, but when the price starts falling, the same trader can switch to shorting and still make a profit. 

Is Short Selling More Profitable?

Short selling has the potential to be very profitable, while longing a stock means you technically have unlimited potential for earning as the price of the stock can keep climbing, shorting can be more profitable in the short term as there are opportunities for margin trading and leveraging with shorting. 

Is Short Selling Illegal?

Short selling is entirely legal and has become a popular trading tool in almost every market, from Wall Street and the stock markets to the burgeoning cryptocurrency markets, short selling is very popular and legal. 

Conclusion

SHort selling represents a next level trading tool that can help you take a big step up in being profitable, being limited to only trading your favourite stock or asset when it is climbing can cut your trading time in half and put you out of the game while you watch the market fall and your money drain away. 

Short selling can also thus act as a hedge against a falling market as if you have a number of long positions and a few short ones, if the entire market goes into the red, you will still have some positions that allow you to profit. 

To get started short selling, it is important to find a platform that offers a number of different assets to trade — from stocks, commodities Forex and cryptocurrencies. PrimeXBT has become well known as a good platform for beginners and experienced traders to short sell due to its large collection of assets to short, and its excellent user experience. To try PrimeXBT for free, sign up here

 

Risk Disclaimer

Cryptocurrency trading involves high risk, and is not suitable for all investors. Before deciding to trade cryptocurrencies, tokens or any other digital asset you should carefully consider your investment objectives, level of experience, and risk appetite.

 

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