Don't be Afraid of Shorting Markets
- Unfortunately, stock markets and prices don't always go up. There are periods where stock prices fall and where going long or buying simply doesn't work. CFDs come in useful here as they offer the ability to profit from a fall in prices as well as a rise in prices. To profit from a fall in prices is referred to as going short or short selling.
- Note that when shorting a stock, a rise in the share price will incur a loss in a short position. Stocks can rise on good news or an upbeat trading statement but can also experience what is referred to as a short squeeze, when shorters rush in enmasse to buy back shares to close their short positions and limit losses.
- The process of shorting or profiting from a share decline has been given a rather bad reputation by the pump-and-dump brigade during the credit crunch, who targeted the banking sector. Some are convinced share prices drop because of institutional shorting but they fail to merely consider institutional selling which may also be a factor in a dropping share price. However in reality, there is nothing inherently evil in short selling; if you believe that a company is run by bad management, then why shouldn't you be able to back your hunch by short-selling the stock? In other cases you might think that a market looks overheated and this is where shorting is the logical choice. This is done by placing a short CFD.
- Shorting offers personal investors a very accessible tool for hedging and making money whether share prices go up or down. Even as an investor, shorting can allow you to hedge your long positions during periods of market turbulence. Not using shorts as a personal investor is like boxing with one hand tied behind your back. You can't protect yourself and you're always going at it from the same side. A sure losing strategy.
- How do you find suitable candidates to short? One way is to watch out for trading announcements; namely profit warnings. Such profit warnings can result in substantial drops in the day of the annoucement; and sometimes the stock price will claw some ground back within the next couple of trading days. You can use this as an opportunity to sell short as such warnings are commonly followed by a number of broker downgrades. Another strategy is to find stocks that are making new yearly lows or to sell short as part of a range trading strategy using support and resistance levels as tops and bottoms.
- Use volatility to your advantage; substantial profits can be made from fear and falling markets. You can use short selling to hedge long stock positions as part of your risk management but it can also be used to extract good profits in its own right if it is used with care and discipline.
- Remember, there are thousands of traders who look for short selling profits, causing shares to peak and trough... Avoid shorting companies with low free floats, low liquidity
or low daily trading volumes, as well as companies that are already heavily shorted (the last are prone to experience a shorting squeeze). Also, avoid shorting companies that are moving up strongly.
- Note that taking a short position is more risky than going long on an instrument as the losses are potentially unlimited (in theory there is no limit on to how much a share price could rise). For instance, suppose you go short on a $1 share of which you've short-sold 1000 units. If another enterprise makes an offer for the company and its stock price shoots up to $1.50, then you have a running loss of $500. However, in practice the risk can be reduced by the use of stop-loss orders (which you put in place to sell out at certain price levels to limit your losses) and guaranteed stop-loss orders. It is also worth noting that it is more risky to go short during a general bull market so you need to be more cautious about taking short positions. Usually, the safest shorting calls in a bull market are on the worst performing shares in the worst performing industry sector.
- Although there are other ways to acquire leverage and other ways to short sell, contracts for difference are suitable for non-professional traders, with manageable contract sizes and low fees making them easy to use. However, beware that ease of use doesn't mean easy profits. The combination of leverage and short selling can be a dangerous mixture, since leverage multiplies losses as well as profits.
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