What is Short Selling?
Selling Short enables a day trader to make a profit when the price of shares of a stock go down.
Most people have no idea that money can be made in a horrible bear market when stocks are rapidly falling. For many, even after an explanation, shorting a stock seems completely unintuitive and strange.
But as you'll soon see selling short for a trader, especially a day trader, is a required and potentially highly profitable trading technique.
Naturally most have never even heard of the term selling short and are only familiar with the process of buying stocks and later selling them. By the way, in case you don't know, normal buying of stocks or any other security is also called various terms such as, Buying Long, Long Position, Going Long, or just plain Long.
For example, if you bought shares of Home Depot (HD), you would have a "long position in HD" or "be Long HD". In the opposite direction, if you had shorted Home Depot, anticipating a falling price, you would have a "short position in HD" or "be short HD".
For day traders, short selling stocks is as natural as buying shares and often profits can be racked up faster than buying. Why? Because of simple market psychology. Fear is a stronger emotion than greed. This is a well known and documented phenomenon in behavioral science.
Market sell-offs can rapidly cascade into free falls. For alert traders selling short, this can mean quick profit gains, sometimes much faster than equivalent long positions over an equal amount of time.
Today's a perfect example to illustrate my point. Look at the daily chart below of the Dow Jones Industrials. Market commentators say the market has been selling off rapidly, possibly due to fears of a another recession.
Another recession? We never got out of the last one!
Anyway, what I'd like you to note is how fast this decline has been. It has only taken 12 days to erase all gains made in the Dow-30 since October 2010! This kind of market action always increases volatility in stocks which generally leads to better trading action and potential gains for traders.
How To Sell Short
A short selling strategy requires that your broker have shares of a stock that you can borrow to sell, and later hopefully buy back at a lower price for a profit. If the price of the stock goes higher than where you shorted the stock, than you are in a losing position. Stop loss orders must be used consistently. You wouldn't make a long trade without a stop, right? The same goes for short trades.
What are some reasons you'd want to short a stock?. The same reasons you might be trading long, except in reverse. Here's a few examples.
- Breakouts below chart patterns.
- Trading pullbacks in a downtrend.
- Price hitting resistance.
- Price retracing to Fibonacci levels in a downtrend.
- Countertrend trading deviation from mean.
- Continuation of an established trend downtrend.
All the methods on my stock day trading strategies page are shown with long position examples, but they can all be used to sell short as well.
Are There Any Risks Selling Short?
Yes. You need to know that when shorting stocks your liability is unlimited. If you buy 100 shares of XYZ @ $50.00 per share, the maximum loss you could suffer if the stock falls to zero would be $5,000. If shorting 100 shares of XYZ @ 50.00, your potential loss could me more than $5,000 if the price moved substantially higher than 50.00.
But, that's what tight stop loss orders are for. Use them every time and you shouldn't have that problem. Besides, day traders don't hold stocks over night. You'll be in 100% cash by the end of the trading session or least you should be.
Not that this would apply to you as a day trader, but you should also know that for longer term trades, shorting stocks has a limit on the potential profit. When you buy a stock there is no limit on how high price can go, but when you are shorting shares, a stock's price can only go to zero.
What is a Short Squeeze?
A short squeeze can occur on any time frame and to various types of traders, but for the purpose of this discussion, we'll stick to an example of a day trader undergoing a short squeeze after a shorting a stock that's in an extended downtrend.
I just mentioned above, that for the last two weeks the market has been in a period of distribution (selling). As you can see in this hourly chart below, CareFusion Corp. (CFN) like most of the market is in a strong downtrend.
There are many traders that have already established short positions in this stock. But, there are always traders that are late to the show.
Smart swing traders already have a profit in this stock built up over days or weeks. But there are always going to be traders that see an established downtrend and jump on too late. Those swing traders selling short yesterday afternoon or day traders short selling this morning hoping that this steep downtrend would continue, got caught in a short squeeze immediately upon the market open today.
The very first 10 minute bar broke two major resistance levels. Three things likely caused this short squeeze. First, traders that immediately had a loss started to buy to cover their short positions. Second, traders sitting on a profit from short entries days or weeks before probably started taking profits, causing more buying activity. Third, day traders that originally closed out their short positions with a loss, possibly started buying CFN after seeing it break resistance.
Within only four 10 minute bars, CFN had broken 5 major resistance levels. At each of these levels, there were most likely stop orders (which turn into market buy orders when hit) placed by short sellers that added fuel to the fire. When short sellers from previous days are sitting on a nice profit and they see this kind of price action, some panic and buy to cover their shorts.
All of this can happen in a very short time frame and cause price to rocket upward as happened with CFN below.
How to take advantage of HIGHLY profitable 'Short Squeeze' situations
I wrote about two strategies in my ebook specifically for profiting from 'short squeeze' price patterns. Traders that have bought my book tell me these two strategies are their favorites.
Click on the ebook to find out what's inside.