When trading the financial markets with derivative products such as Contracts for Difference, or CFD, traders can either open long positions to profit from a bullish price movement, or open short positions to take advantage of bearish movements. The latter scenario is often referred to as “short-selling”. Let’s discover what short-selling is, how to take advantage of it and if you should integrate it in your trading strategy.
What is short-selling?
Short-selling can be described as a financial operation wherein an investor sells an asset he doesn’t possess, expecting its price to decline in the future. The goal is therefore to profit from this anticipated decrease by borrowing the asset, usually from its broker, and selling it in the market before buying it again at a lower price to make a profit. Traders employ various methods to analyze the market and anticipate a bearish price movement, with two commonly used approaches being technical analysis and fundamental analysis.
Technical analysis involves analyzing historical market data to identify trends, significant price levels, and price patterns that can provide insights into future price movements. Conversely, fundamental analysis focuses on evaluating an asset's intrinsic value based on fundamental factors, such as the current economic cycle, the fundamentals of a company or asset, and its growth potential, to determine if this asset is currently over-priced or under-priced.
Another type of analysis often underestimated here is sentiment analysis. Sentiment analysis plays a crucial role in helping traders assess the prevailing market sentiment towards a specific asset. By monitoring sentiment trends, traders can identify shifts in market sentiment over time, which can have implications for short-selling strategies. When sentiment analysis reveals widespread negative sentiment, it suggests a greater possibility of price declines, which can align with potential short-selling opportunities, particularly in event-driven short selling and news trading.
Pros of using short-selling strategies
● Great way to profit from falling markets.
● A good option for hedging.
● Useful for capitalizing on over-valued assets.
● Often used with derivative products, which means that it is possible to start small thanks to margin and leveraged trading.
● With long and short positions, you can potentially make profit from all market conditions (bullish and bearish) through a single trading platform.
● When used with long trading on the same portfolio or position, short trading can help to reduce overall risk and volatility of the position or portfolio.
● Short-selling also offers the flexibility to use different trading strategies
Cons of using short-selling strategies
● Depending on the level of leverage used, capital loss can be large.
● Losses can potentially be unlimited.
● Going against the primary trend.
● Market manipulation can trigger short-squeeze.
● It is sometimes complex to differentiate a bearish trend or a significant correction from a short pause in a bullish trend.
● Short-selling certain markets can be subject to limitations.
● Used in combination with margin trading, short-sell trading is associated with trading fees.
● If you’re short-selling stocks and the related company distributes dividends, you need to pay it.
● Short-selling can sometimes be limited by financial centers when the price of an asset drops quickly within a single trading session.
When should you short-sell the market?
● During bearish or declining market conditions.
● When an asset or overall market fundamentals are deteriorating.
● To profit from overvalued assets that might soon reverse and correct.
● When you observe a shift in market sentiment that leads to price declines due to overall pessimism or negativity.
● To protect your longer term bullish trading positions against short-term corrective movements (hedging).
What should you take into account before short-selling an asset?
● Overall market trend and conditions.
● Dominating market sentiment.
● Your borrowing availability and short-selling costs.
● Short interest and liquidity levels.
● Risk of short-squeeze.
● Regulatory requirements and restrictions in your jurisdiction or the asset you’re targeting.
How to short an asset with ActivTrades in 7 steps
- Open a live trading account.
- Analyze the market to find an asset stock with downside potential or short-sell the stocks you own to protect them from a temporary bearish movement.
- Set up your trading order to open a short position (type of trading order, entry price, quantity, level of leverage).
- Add money management features depending on your risk management rules in your trading plan (stop-loss and take-profit orders that will automatically close your position once they reach pre-determined loss or profit levels, respectively).
- Confirm your order to open your short position.
- Monitor your short-selling position according to the evolution of the market conditions.
- Close your short position if you consider it necessary (even if it hasn’t touched your protective orders yet).
When trading with ActivTrades, you have the option to open both long and short positions through margin trading accounts. To enable the ability to simultaneously hold both a long and short position on the same asset, you need to activate the "hedging" feature through the "Order Handling Mode" option within the personal area, specifically under the "Accounts" tab in the "My Account" section.
Alternatives to short-selling to profit from bearish market conditions
In addition to short-selling, traders have several alternative strategies to profit from bearish market conditions. Before you decide which approach is best, you need to think about your investment objectives and your risk tolerance, as well as understand the mechanics and risks associated with each alternative strategy.
Options
The first alternative solution is the purchase of put options, which provides traders with the right to sell an asset at a predetermined price within a specific time period. As the price of the asset decreases, the value of put options rises, presenting an opportunity for profits while avoiding the unlimited risk associated with short-selling.
Furthermore, traders can use strategies like selling naked call options, bear put spreads or bear call spreads, but these are rather used by experienced traders.
Inverse ETFs
Traders can also consider Inverse Exchange-Traded Funds (ETFs), also called Bear ETFs or Short ETFs, which are specifically designed to move in the opposite direction of a particular index or sector. These ETFs offer traders an inverse exposure to the underlying assets, enabling them to profit from market downturns by buying shares of these ETFs.
Futures
It is also possible for traders to use futures contracts, which involve agreements to buy or sell assets at predetermined prices on specified future dates. By selling futures contracts, traders can potentially profit from expected price declines in a range of financial markets.
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