A short position or short selling in finance and investing refers to a situation where an investor sells a financial security asset at a high price and aims to repurchase it at a lower price to make a profit.
Short positions can be very profitable in falling markets where the value of an asset like a stock, currency pair, or commodity is declining.
Most investors use short positions to hedge their long positions on other holdings and reduce their overall portfolio volatility.
Short selling is also inherently risky, since the price of a security asset can theoretically rise indefinitely. This could result in massive losses for traders and investors if they open a short position and the price of the asset keeps going up.
What is a Short Position?
A short position is a financial operation in which investors sell borrowed securities on the open market, anticipating a decline in their price. In a short position, the investor perceives a security (such as a currency, commodity, or stock) to be overvalued and sells it with the expectation of repurchasing it at a lower price, thereby securing a profit.
Short selling is legal in most financial markets but is subject to specific regulations and restrictions that vary by country and market. Regulations in the financial industry are designed to maintain market stability and prevent abusive practices.
There are three types of short positions: covered short selling, naked short selling, and synthetic short selling. Covered short selling involves borrowing the securities before selling them on the open market, ensuring the securities can be delivered to the buyer, and is the most commonly practiced and regulated form. Naked short selling, generally illegal in many markets, occurs when an investor sells securities without first borrowing them, leading to potential delivery failures and market instability. Synthetic short selling uses derivatives like options or futures to mimic the effect of a short position without directly shorting the underlying security, providing an alternative method to profit from anticipated price declines.
Short positions in the stock market consist of borrowing a stock from a broker and then selling it in the stock market, expecting its price to fall. The short seller buys the stock back at a lower price and returns it to the broker. The price difference constitutes the profit. Short selling stocks is not forbidden to retail investors and traders, who are allowed to short stocks or securities directly or use derivatives like option contracts.
Short position is one of the most common Forex terms, and it is a widely used operation, particularly in this market.
What does Short Call Position Mean?
A short call position occurs when an option trader sells a call option contract on an underlying asset, anticipating a decrease in the asset’s value. A short call position grants the buyer of the call option the right, but not the obligation, to purchase the underlying asset from the seller at a specified price (the strike price) by a specific date (the expiration date).
If the underlying asset’s price decreases or remains unchanged by the expiration date, the call option expires worthless, and the seller retains the premium received from selling the option.
The primary distinction between a short call and a traditional short position is in the nature of the transaction. Short calls involve selling call option contracts rather than the asset itself, whereas a traditional short position involves directly selling the asset.
How Does a Short Position Differ from A Long Position?
A short position differs from a long position in that while a short position involves selling securities, anticipating their prices drop, a long position involves buying a security asset, anticipating its price will rise.
A trader who takes a long position on a security like a currency, stock, or commodity will profit if its price appreciates with time. A trader who opens a short finance position on the same securities will profit if the value declines.
An important aspect to remember when opening “short vs long positions” is that the investor or trader must either borrow or own the underlying security asset to complete the buying or selling transaction.
Does Short Position Mean Selling?
Yes. Taking a short position generally means selling a security that an investor or trader does not currently own with the expectation that its value will decline.
In a process of short selling, the investor borrows the security from a broker or another party, sells it, and then buys it back at a lower price. The investor then profits from the price difference.
What is an Example of a Short Position?
A notable example of a famous short position was made by George Soros in 1992, famously known as “Black Wednesday”. Through his Quantum Fund, Soros bet against the British pound by shorting it, believing that the Bank of England could not keep the pound above its agreed exchange rate in the European Exchange Rate Mechanism (ERM).
Soros recognized that the British pound was overvalued and that economic conditions in the UK were not strong enough to support the currency at its pegged rate. He borrowed and sold large amounts of pounds on the market, anticipating that the currency would devalue.
On September 16, 1992, the British government was forced to withdraw the pound from the ERM and devalue the currency after failing to defend it against speculative pressure. This event, known as Black Wednesday, resulted in Soros making an estimated profit of $1 billion.
How do Traders Profit from Short Positions?
A trader profits from short positions by selling a borrowed asset at a high price and then buying it back at a lower price. First, traders borrow shares of a stock from a broker. The traders then sell these borrowed shares on the open market at the current market price. Traders can buy back the same number of shares at a lower price if the stock price decreases as anticipated. After repurchasing the shares, traders return them to the broker.
For example, a Forex trader believes that the Euro (EUR) is overvalued and will weaken compared to the US Dollar (USD). The forex trader opens a short position on the EUR/USD currency pair by borrowing 1,000 Euros from their forex broker and sells them on the open market at the exchange rate price. Assuming the exchange rate is 1 EUR = 1.40 USD, the trader will receive $1,400 after selling the 1,000 Euros. If the value of the Euro weakens as the trader expected, say to 1 EUR = 1.20 USD, the trader can repurchase the Euros at that lower price for a total of $1,200. Once the forex trader returns the 1,000 Euros borrowed to the Forex broker, a difference of $200 ($1,400 – $1,200 = $200) remains as profit.
Most traders use chart pattern signals, for example the head and shoulders pattern, to identify opportunities to open a short position.
What Chart Patterns Signal a Potential Short Position in Trading?
The main chart patterns signaling a potential short position in trading are the head and shoulders pattern, double top pattern, and rising wedge pattern.
The head and shoulders pattern consists of three peaks: a higher peak (head) between two lower peaks (shoulders). In a head and shoulders pattern, traders enter a short position when the price breaks below the neckline, which is the line connecting the lows of the two troughs.
The double top pattern forms after a strong uptrend and consists of two peaks at approximately the same level. The double top pattern signals a short position when the price breaks below the support level, which is the low point between the two peaks.
The rising wedge pattern consists of two converging trendlines sloping upwards. Traders enter a short position in a rising wedge pattern when the price breaks below the lower trendline of the wedge.
Most traders and investors use bearish chart patterns in combination with indicators, candlestick patterns, or another type of chart pattern to improve the chances of their predictions.
What are the Risks Involved in Trading for Short Position?
The risks involved in trading short positions are listed below.
- Unlimited loss potential: The potential losses when short selling is theoretically unlimited since a security asset, like a stock, can only decline to zero but has no upward limit.
- Forced liquidation and margin call: Traders typically borrow a margin from their broker when opening short positions. If the stock or asset price appreciates sharply against a trader’s sell position, the broker issues a margin call, forcing the trader to deposit additional funds into the account to cover the potential losses. Failure to meet the margin call means the broker closes the short positions at a loss.
- Increased borrowing costs: Holding short positions attracts extra borrowing costs like paying interest, dividends, and trading commissions on the borrowed shares to the broker. The little extra costs involved in shorting securities can eat a big chunk of profits.
- Unexpected short squeeze or buy-ins: Traders opening short positions risk facing sudden and dramatic price increases due to unexpected market manipulation, known as short squeezes. A notable example is the GameStop short squeeze in early 2021, where short sellers faced total losses exceeding $10 billion, according to Ortex Analytics.
How are Entry and Exit Points Determined when Taking a Short Position?
Entry and exit points when taking a short position are determined by technical chart tools and fundamental analysis. Traders use technical chart tools like trendlines, indicators (such as moving averages, RSI, or MACD), and candlestick patterns like engulfing candles or hanging man, to determine their entries for short positions. Traders use expansion projection tools like the Fibonacci extension to target exit points for their trades.
Traders combine technical analysis with fundamental news or sentiment analysis to confirm that macro market dynamics are in line with their short strategy, thus increasing the reliability of the short signal.
An example of a common entry-to-exit strategy is the use of moving average crossovers with a bearish candlestick pattern. Traders use the 20-period moving average and the 50-period moving average and only take a short entry if the 20-period crosses the 50-period from above to below and an engulfing candle subsequently forms. The entry point is at the opening of the next candlestick after the engulfing. The exit point will be the next point where both moving averages intersect again or at a 100% price projection level on a Fibonacci tool.
What Factors Influence the Decision to Enter a Short Position in Trading?
The factors influencing the decision to enter a short position in trading are listed below.
- Technical analysis: Traders consider bearish chart patterns like head and shoulders, descending triangles, double tops, technical indicators like overbought RSI or stochastic oscillators, and volume analysis to decide whether to enter a short position.
- Fundamental analysis: Investors focus on fundamental factors such as asset overvaluation and financial underperformance to indicate that a short position is a correct trade.
- Sentiment analysis: Traders monitor sentiment indicators like the put/call ratios and institutional shorts interest to establish whether investors and market participants are interested in shorting opportunities.
- Risk assessment: Traders usually assess whether the risk-to-reward ratio of taking a short trade is worth it.
- Market conditions: Volatile markets are usually quite attractive to short sellers because of their profit potential. Traders consider whether their account has enough leverage to handle the large swings in such markets before opening a short position.
How does Leverage Impact Short Position Trading?
Leverage impacts short position trading by enabling traders to amplify their exposure and control larger short positions beyond their initial investment. Leverage allows a trader to borrow capital from their broker to increase the size of their short position. For instance, with a leverage ratio of 1:100, a trader can control $100 worth of a short position with only $1 of his capital.
Profits increase significantly with leverage in trading if the trader’s forecast is correct and the short position pays off. Leverage increases losses in a mirror-image manner if the trader’s short forecast is incorrect.
Can Short Positions Be Held Indefinitely?
Yes, a short position can be held indefinitely. There’s no technical limit to how long a trader can hold a short position. However, brokers may demand additional funds if the stock price rises. Borrowing costs and fees associated with maintaining short positions accumulate over time. The risk of a short squeeze, where stock prices surge unexpectedly, poses significant financial threats. Regulatory bodies and brokers may impose time limits or recall borrowed shares.
What are the Advantages of Short Positions?
The advantages of short positions are listed below.
- Allows traders to profit in falling markets: Short positions allow traders and investors to profit from bear markets when stocks and securities decrease in price.
- Enables hedging against market decline: Short positions make it easy for traders to protect their long positions against potential losses during market downturns.
- Increases market liquidity: By allowing short traders in the market, short positions increase trading activity, which balances market liquidity and promotes efficient price discovery.
- Reduces portfolio volatility: Opening short positions helps investors balance the exposure of both long and short positions, thereby reducing their overall portfolio volatility.
- Allows leveraged trading: Short selling enables a trader to utilize leveraged accounts, thereby amplifying potential profits when market analysis proves accurate.
What are the Disadvantages of Short Positions?
The disadvantages of short positions are listed below.
- Magnifies potential of infinite loss: Traders can incur losses exceeding 100% of their initial investment given the absence of an upper limit on the price of a stock or security.
- Increases borrowing costs: Opening and holding short positions involves paying interests, dividends, and commissions to the broker for the borrowed shares, which reduces profits.
- Increases risk to short squeeze: Short positions may force traders to buy back their securities at a loss if the security’s price begins to drive up in a short squeeze.
Which Brokers Support Effective Short Positions in Trading?
The top five best brokers that support effective short positions in trading popular security assets like forex, stocks, commodities, and indices include Pepperstone, XM, AvaTrade, FP Markets, and IC markets. These brokers are regulated by the relevant financial authorities and offer good spreads and commissions, a user-friendly trading platform, and multiple account options to suit every trader’s trading style. They are also well-established in the industry for offering their clients the best Forex Broker services.
Is Short Selling Bad?
No, short selling is not inherently bad.
Proponents contend that short selling enhances market efficiency by facilitating price discovery and providing liquidity. Short sellers play a crucial role in the price discovery process, as stated in the paper ‘Short Selling and Stock Prices,’ published in 2008 by Ekkehart Boehmer and J. Julie Wu in the ‘Review of Financial Studies.’ Short sellers can uncover and expose overvalued companies, thereby correcting inflated asset prices.
Critics argue that short selling can exacerbate market downturns by increasing selling pressure on already declining stocks and can contribute to market volatility, potentially destabilizing financial systems.