Make Money in a Falling Market Using Short Selling

Submitted by Marco Palmero on 8 February, 2008 - 20:45

Short Selling in a Falling Market

Professional share traders and investors who trade and invest money for a living use sophisticated methods in their line of work one of which is short selling. You may or may not know that you can actually make money in the sharemarket (stockmarket for our American counterparts) anytime - it doesn't matter if the market is trending up and very bullish, stagnant and going sideways or falling in a bearish market situation. There are many sophisticated ways to successfully trade the market, some gurus may even pass them off as "secrets." In this article we will examine how to make money in a falling market using a method called short selling.

What is Short Selling?

Simply put, short selling a stock involves you selling something you don't own. The term has a few usages such as: "shorting", "going short" or simply "short a stock". You would short a security (share, stock, index or forex currency) if you think the equity is going to fall in the future to benefit from the fall in price. Going short is the opposite to going long - which is the normal expectation of buying low and selling high to gain a profit. Shorting a security is a bearish stance and having a "long view" doesn't usually mean a long term view in this context, it means a bullish view.

How do you Make Money When You Short Sell?

Ok, so I have to sell something I don't own. You've lost me there... To sell something you don't own you have to borrow the security that you are going to sell. In theory using this method to make money when you short sell, you would "borrow" the shares to sell at a high price. Then later, then the price of the security has dropped, you would buy back the security to return the loaned shares back to the owner. You in turn pocket the difference between the price you sold the security at and the price you bought back the stock.

So short selling involves a security which you: Borrow. Sell. Buy it back at a lower price. Pocket the difference. Return loaned stocks/shares to owner.

For example in share trading terms, if you the professional share trader short sells XYZ at $20 and the stock falls by $5 in the following days, you would have gained a profit of $5 per share you shorted, minus brokerage and interest fees. On the other hand if you shorted XYZ again at $20, but instead of falling, the stock rose by $5, then you would be out of pocket for $5 per share and the brokerage and interest costs because you would still need to return those loaned shares.

In forex (foreign exchange) terms, say the AUD/USD currency pair was being quoted at 85 cents or US$0.8500 and you decided to short the pair. If the currency falls by a cent to 84 cents or US$0.8400; you would have profited 100 pips. On the other hand if the pair decided to head up to 86 cents or US$0.8600 then you would have lost 100 pips on the trade. Just a quick note that its rare to see the Aussie dollar to move 100 pips in a day unlike the Euro/US pair and sometimes the Japanese Yen.

I Want to Know How Short Selling Works

You're probably wondering how this really works as I did when I learned about this sophisticated technique a few years ago. I thought back then: Why would people loan out their securities for this? How does the back office stuff work? Just tell me how short selling works?! Well, in principle when institutions, traders and professional investors short sell they are borrowing shares to sell. We’ve heard that already. Where do they borrow the shares? From a prime broker, investment banks, superannuation funds and hedge funds. Why do they happily lend out shares? It's all about their strategy. The security lending institution may have an opposite view to you. You may be bearish, and they are bullish. So in this perspective, they are making a guaranteed return on stock they would be holding long anyway because of their stance and perhaps also because of teir benchmark requirements. The guaranteed return is the interest you pay for borrowing the stock. (In forex, this works a little different – if the currency you are shorting has a high interest rate differential with the other country's official bank rates you may be actually receiving interest).

Why Use Short Selling?

Most professional short term traders would use short selling as a tool to capitalise on rapid drops or a downtrend on a security. There is also potential to use short selling as a tool to mitigate risk in order to hedge losses on a portion of your stock holding. (Another way to mitigate bearish risks is through use of options – but that's another story)

Get Me Some Short Sell Action!

If you live in UK or Australia among other countries there are good news! If you live in USA, you may be restricted in your exposure to direct short selling and may need to resort to using options strategies for similar exposure. USA retail investors are not allowed to invest in hedge funds.

Short selling is usually the world in which hedge funds revolve. For investors this is your route for getting some short selling exposure. For sophisticated professional traders there are derivatives such as put warrants, CFDs and forex to give you some short selling action.

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