Considering Short-Selling In The Bear Market? Check Out These Key Principles

Considering Short-Selling In The Bear Market? Check Out These Key Principles

The financial markets are brimming with mind-bending instruments and activities, and for many, short selling falls within that category. 

The idea of profiting from a depreciating asset does not come naturally to most. The experiences one acquires from day-to-day economic activities would suggest the opposite is true. The retailer, the wholesaler, the real estate owner and the business investor only profit if they can sell their assets for a higher price than what they bought them for.

Short selling circumvents the norm. It allows investors and traders to profit from the erosion of value in a security, commodity or asset. Jesse Livermore, one of the greatest traders of all time, famously shorted the Dow Jones in 1929, making $100 million (approximately $1.5 billion in today’s money) from the drop that soon followed. 

Evidently, short selling can be a lucrative investment strategy. If the curious investor ventured deeper into the concept, however, they’re likely to be met with more confusing terminology. Margin trading, short locates and theoretically unlimited losses are all part of the short-selling journey. 

So what does it all mean, and how can you start shorting? 

Short-Selling Explained

Consider an analogy. 

Suppose your friend John has a Model 1 IKEA chair. You need money, so you ask to borrow his chair, and you reach out to your friends Moe and Adam. Moe is looking for a Model 1 IKEA chair, so you sell it to him for $300. Adam has a Model 1 IKEA chair he doesn’t want, so you buy it from him for $200. When you give John back the Model 1 IKEA chair, you will have made $100, and John will have gotten his chair back.

This is short-selling. When a short seller initiates a short sale, it’s with a stock they’ve borrowed from their broker. If the short seller can buy back the stock at a cheaper price than they sold it for, they can profit from the difference. When they return the stock to their broker, it will be identical to the one they took at the time, so the broker loses nothing. 

But what if the short seller can’t return the shares they borrowed? 

In the analogy above, John placed blind trust in your ability to return his chair to him. Brokers will not do the same. To circumvent any possibility of the short-seller failing to return their borrowed shares, brokers demand that short sellers take out loans and maintain a set amount of cash in their accounts as they hold their short position. This is called trading on margin.

If the stock an investor has shorted increases in value, the short-seller will start compounding unrealized losses. This increases the likelihood of short sellers failing to return their shares, so brokers will take action. Eventually, a margin call will be made by the broker, demanding that the short-seller put up more cash as collateral or risk having their position liquidated. The broker can liquidate a short seller’s position immediately if they do not meet their margin requirements.

By enforcing margin accounts, brokers create a system to receive the borrowed shares back from the short seller every time. The short seller’s cash is used as collateral. As long as the short seller continues to meet the margin requirement, or if their position is showing unrealized profits, they can maintain their short position.

Locates, Risk And Short Interest

Short selling has a few fundamental concepts that every short seller should know. These include: 

  • Short locates:

    • All short positions are created with borrowed shares. Most of the time, short sellers borrow shares from their broker. Thus, to be able to short a stock, a short seller’s broker must have the shares required. If the broker does not have the shares immediately available, the short seller can request a short locate, which asks the broker to locate sales to sell short.

  • Short Interest:

    • Short interest is the number of shares that have been sold short and remain outstanding for a particular security. High short interest in a security means that many of its shares are shorted by the market. An extreme example of high short interest is GameStop Corp. GME, which had 141.8% of its shares short in January 2021.

  • Theoretical risk:

    • In long positions, the theoretical loss is capped by the distance from the stock’s price to $0. If you have one share of a $20 stock and it goes to $0, you lose $20. The theoretical loss from short selling is infinite because a security’s price can rise infinitely. Thus, risk management is a key component of responsible short selling. Placing stop losses is considered an essential component in any short-selling strategy because it ensures losses remain manageable. 

A Quality Short-Sale Broker

Short selling can be complicated and unnatural, but with time, trades can quickly internalize short-selling concepts. 

Success in short selling takes many forms, but all success begins in one place: the broker. One broker that has made significant strides in the short-selling department is TradeZero, the winner of the Benzinga Global Fintech Award for Short Selling in 2020 and 2021. For the short seller, TradeZero is a unique place.

The company is actually made up of three separate broker-dealers in three different jurisdictions but specializes in providing some of the hardest-to-find locates on the market, meaning investors have a much higher likelihood of finding stocks to borrow for their short positions. 

TradeZero also reports taking its short-selling abilities to new heights with its patent-pending credit back features, which can allow an investor to sell any unwanted or unused locates to other TradeZero users and recoup some of their locate costs.

Want to take a stab at short-selling? 

Click here to learn more about short-selling with TradeZero.

This content (“Content”) is produced by Benzinga in partnership with TradeZero. TradeZero does not endorse the Content and makes no representations or warranties with respect to the accuracy of the Content or information available through any linked third-party sites.  Benzinga may receive compensation for introducing customers to TradeZero. TradeZero provides self-directed brokerage accounts to customers through its operating affiliates (“TradeZero Broker Dealers”): TradeZero America, Inc. a registered broker-dealer and a member of FINRA and SIPC; TradeZero Inc., a dealer registered with the Securities Commission of the Bahamas; and TradeZero Canada Securities ULC, an IIROC member firm and member of CIPF. TradeZero Broker Dealers do not provide financial or trading advice and do not make investment recommendations to their customers. This communication does not constitute an offer to sell or a solicitation to buy any security or instrument which it may reference. There is a risk of loss in online trading of securities including equities and options. Trading on margin is for experienced investors only as the amount you may lose can be greater than your initial investment. Likewise, short selling as a securities trading strategy is extremely risky and can lead to potentially unlimited losses. If you have any specific questions about TradeZero’s brokerage services please reach out to the TradeZero Broker Dealer in your jurisdiction.

This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investing advice.

Featured photo by m. on Unsplash

Posted In: Partner ContentTradeZeroShort SellersShort IdeasTrading Ideas