What is a Short Position

Introduction

A trader creates a short position when they sell a security with the intention of buying it back at a lower price later. When a trader anticipates a potential decrease in a security's price, they may choose to short it.

There are two distinct types of short positions: naked and covered. Selling a security without owning it is known as a naked short. When a trader engages in a covered short, they borrow shares from a stock loan department and pay a borrowing rate for the duration of the short position.

You can create short positions in the futures or foreign exchange markets at any time. In this article, we look at what is a short position.

What is a Short Position in Trading?

It is important to realize that a trader has an infinite potential for losses and a finite potential for profits when opening a short position. This is due to the fact that the stock's distance from zero determines the maximum profit potential. A stock, however, may increase for years and reach a number of greater peaks. The possibility of a short squeeze is one of the riskiest parts of going short.

Short positions are shares that investors borrow, sell, and plan to buy back later. Investors risk losing money on their short positions when the prices of the underlying assets rise.

In addition to the pressure of growing paper losses, holding a short position may get harder because the margin needed as collateral to guarantee that the investor can repurchase the shares and give them back to the broker increases in tandem with the price of the underlying asset.

Investors must repurchase shares to cover their position during a short squeeze. If enough short sellers are compelled to buy back shares at the same time, the price of the underlying asset may rise sharply, creating a spike in share demand.

In one well-known instance, short sellers rushed to cover their shares, sending Volkswagen's stock skyrocketing in October 2008. During the short squeeze, the stock increased from about €200 to €1,000 in just over a month.

How to Set Up a Short Position

Before they can place a short order, an investor must have access to this type of order through their brokerage account. To open a short position, you must have a margin account, because a short trade will result in margin and interest charges.

Order data is entered on the order screen, just like for any other trade, once you have the appropriate account type and any required permissions.

Just keep in mind that you are selling first to establish a position, then sealing the deal by repurchasing the asset at a lower cost later on. When one is trading shorts, the buy price is the exit, and the sale price is the entry. Additionally, it's critical to keep in mind that trading on margin carries interest, margin requirements, and sometimes additional brokerage fees.

Traders often participate in short selling for speculative purposes and to hedge their positions. When opening a short position, traders are required to have a margin account and pay interest on the borrowed shares for the duration of the position.

The Financial Industry Regulatory Authority (FINRA), along with other regulatory bodies such as the New York Stock Exchange (NYSE) and the Federal Reserve, have established minimum requirements for the maintenance margin in margin accounts.

A broker is in charge of locating borrowable shares and returning them at the conclusion of the trade. Standard trading platforms with brokers authorized to facilitate margin trading make it easy to execute the trade.

When engaging in short selling, traders follow these steps:

• A seller initiates a short position by borrowing shares, typically from a broker-dealer, with the expectation of buying them back at a lower price to make a profit.
• The investor subsequently sells these borrowed shares to buyers who are willing to pay the market price. The trader anticipates that the price will continue to drop, allowing them to acquire the shares at a more favourable price.
• When closing a short position, a trader buys back the shares at a hopefully lower price and returns them to the lender or broker.

Traders must take into account any commissions on trades or the interest the broker charges.

Timing and Conditions

Timing plays a critical role in the art of short selling. Disappointing earnings or other negative developments can easily erase a significant increase in stock value, and stocks often experience rapid declines compared to their slower advances. On the other hand, getting into the trade too soon can pose challenges to maintaining the short position due to the expenses and potential losses that increase when the stock rises quickly. Short sellers often seek out opportunities during specific market conditions.

Decline in fundamentals

Stock fundamentals can decline due to a variety of factors, such as a decrease in revenue or profit growth, mounting business challenges, and escalating input costs that squeeze margins. Worsening fundamentals may suggest an economic slowdown, unfavourable geopolitical events, such as the possibility of war, or bearish technical indicators, such as reaching new highs on decreasing volume.

Bear market

Those who understand the importance of market trends have a higher likelihood of making successful short-sale trades in a bear market compared to a bull market. Investors who specialize in short selling thrive in situations where the market experiences a rapid, widespread, and significant decline, allowing them to generate substantial profits.

Bearish technical indicators

When technical indications support the negative trend, short sales could be successful. These signs could include a collapse below a significant long-term support level or a bearish moving average crossing, such as the death cross. A bearish moving average crossover occurs when a stock's 50-day moving average falls below its 200-day moving average. A moving average is the average price of a stock over a predetermined period. If the current price breaks the average, either upward or downward, it may indicate a new trend in prices.

High valuations

Periodically, prices in some industries or the market overall may rise to extremely high levels because of widespread optimism about the long-term outlook for such industries or the overall economy. Market experts refer to this stage of the investing cycle as "priced for perfection," as investors will inevitably face disappointment when their high expectations fail to materialize. Experienced short sellers may wait until the market or sector turns over and starts its declining phase rather than jumping in on the short side.

Example of a Successful Short Position

A trader believes that after Amazon releases its quarterly data, the stock is about to plummet. The trader plans to short the company, so he borrows 1,000 shares from his stock loan department in order to take advantage of this opportunity. Subsequently, the trader proceeds to sell the 1,000 shares short for $1,500. The business forecasts lower-than-expected sales in the upcoming weeks and issues a weaker-than-expected forward quarter guidance. The stock then falls to $1,300 as a result, and the trader purchases to close out the short position. A gain of $200 on each share, or $200,000, is realized from the trade.

Short Selling Strategies 

Profit

Imagine a trader who thinks the price of a certain stock, which is $50 right now, will go down in three months. They acquire 100 shares and then sell them to someone else. They sold 100 shares that they didn't own but had borrowed, so they are now "short" those shares.

A week later, the shorted company posts terrible quarterly earnings, causing the stock to drop to $40. The trader gets rid of the short position and replaces the borrowed shares with 100 shares bought on the open market for $40 each. Without fees and interest on the margin account, the trader made $1,000 on the short sale. Here's how to figure that out: $50 minus $40 equals $10, and $10 times 100 shares equals $1,000.

Loss

Assume, using the above-mentioned example, that the trader chose to hold onto the short position rather than closing it at $40 in order to profit from a potential price decrease. However, when a rival moves in with a takeover offer of $65 per share to acquire the business, the stock skyrockets. Based on the following estimates, the trader would have lost $1,500 on the short sale if they chose to close the position at $65. $50 minus $65 equals $15, and a loss of $15 x 100 shares equals $1,500. In this case, the trader had to purchase the shares again at a much higher price to cover their position.

Hedge

Hedging's primary objective is protection, as opposed to speculation's profit-driven nature. The goal of hedging in a portfolio is to minimize losses and safeguard gains. Hedging comes at two costs. In addition, there is the real cost of hedging, which includes things like short-sale costs and protective options contract premiums. There is also the opportunity cost of reducing the portfolio's upside in the event that markets continue to rise. A portfolio that closely tracks the Standard & Poor's 500 Index (S&P 500) would only record about half of the gain, or 7.5%, if 50% of the portfolio is hedged and the index increases by 15% over the course of the following 12 months.

Pros and cons of a short positions

Conclusion

Although it may seem illegal to sell something you don't own, strict controls govern the market. Traders who believe a security's price will drop soon may take a short position by selling it first and then buying it later at a lower price. Generally speaking, traders borrow stock from their brokerage to establish a short position. In other words, going short calls for a margin account in addition to other possible authorizations and broker costs.