Short in trading: The path to profit through market downturns

In the world of trading, there is a strategy that allows you to make money on falling asset prices. This is called short selling, or short selling. Shorting is not just a mechanism for making money during bearish market trends; it is an art of foresight and strategy that requires a deep understanding of the market and the courage to resist the general trend.

The basics of short

Shorting is selling an asset that you do not yet own with the intention of buying it back at a lower price in the future. The trader borrows the asset, sells it on the open market, and when the price falls, buys it back to repay the loan. The difference between the sale and purchase price is your profit (less any fees and interest on the loan).

Example

Imagine that the stock of company X is trading at $100 per share. You, analysing the market, assume that the share price is about to fall. You borrow 10 shares and immediately sell them at the current market price ($1000 total). A week later, the stock price drops to $90 per share. You buy back 10 shares at $90 ($900 total) and return them to the owner. Your profit is $100 (less any fees and interest for borrowing the shares).

Risk and reward

It is important to realise that shorting involves high risk. If the price of an asset rises instead of falling, the trader's losses can be theoretically unlimited. Therefore, successful short traders often use careful analysis and set strict loss limits.

Example

If in the previous example the stock price of Company X had risen to $110 instead of falling, you would have had to buy it back for $1100, resulting in a $100 loss. It is important to set stop-loss orders to minimise potential losses.

Technical and fundamental analysis

Technical and fundamental analysis are two fundamental pillars in the world of trading, especially when it comes to strategies such as short-selling. Let's take a closer look at how each of these types of analysis contributes to informed trading decisions.

Technical analysis

Technical analysis is a method of evaluating financial instruments by analysing statistical data derived from trading activity, such as price and volume. This type of analysis is based on the premise that historical trading data and charts can predict future price behaviour.

Basic tools of technical analysis

• Charting: Used to identify trends and patterns on price charts such as head and shoulders, double bottoms, flags, and others.

• Technical indicators: RSI (relative strength index), MACD (moving average convergence-divergence), Bollinger Bands and others help to determine the moments of overbought or oversold assets, as well as potential trend reversal points.

• Trading volume: Analysing volumes can confirm the strength of a trend. For example, rising prices with high volumes may indicate a strong uptrend.

Example: If a stock chart shows a downtrend with confirmation from trading volume and the RSI indicator shows oversold, this can be a good signal to enter short.

Fundamental analysis

Fundamental analysis examines the intrinsic value of an asset by assessing the economic, financial, political and social factors that may affect its future value. This type of analysis attempts to determine whether an asset is overvalued or undervalued at current price levels.

Key aspects of fundamental analysis

• Financial indicators: Profitability, earnings per share (EPS), P/E ratio (price/earnings) and other indicators help to assess the financial health of the company.

• Economic indicators: Inflation rates, interest rates, unemployment rates and GDP affect the overall health of the economy and can have an impact on financial markets.

• Industry and market trends: Analysing industry trends and general market sentiment can provide additional context for investment decisions.

Example: If analysis of a company's financial statements shows an increasing debt load and declining profitability in an increasingly competitive industry, this may indicate potential risks to its stock and signal a short position.

The combination of technical and fundamental analysis provides a trader with a comprehensive view of the market, allowing a more informed approach to making decisions about entering or exiting positions, including short positions. Technical analysis helps determine “when” to buy or sell, while fundamental analysis answers the “why” question. Using both approaches together can significantly increase the probability of trading success.

Market psychology and shorts

Particularly interesting is the moment of shorting's influence on market sentiment. Large-scale shorting attacks can cause panic among investors, accelerating price declines. However, such actions can backfire on the trader if the market perceives the decline as a buying opportunity, causing prices to rise.

Example

When Tesla announced lower-than-expected sales, many traders began shorting its stock, assuming a decline. This led to an accelerated price decline, but when Tesla announced a new breakthrough product, the stock went up sharply, causing losses for traders who had been shorting.

Conclusion

Short trading is a complex but potentially profitable tool in the arsenal of an experienced investor. It requires not only knowledge and skills, but also psychological stability to make counterintuitive decisions. Before diving into the world of shorts, it is important to deeply study all aspects and potential risks of this strategy.

This article is provided for informational purposes only. It does not contain investment advice, suggestions, or calls to action regarding the purchase or sale of any securities or other financial instruments. Before making any financial decisions, it is always advisable to conduct a thorough analysis and, if necessary, to consult a qualified financial professional. The authors and publishers of this article are not liable for any possible losses or other damages resulting from the use of the information provided.