Short Trading: What is Short Selling?

When trading long or short on the market, short trading is an often misunderstood style of trading!

Long and short refers to the direction of trade, as opposed to the timeframe of long term or short term.

So short selling a stock or CFD means that you sell the stock, and if the stock price falls, then you can profit from this fall in price, assuming you over trading costs.

Short Selling Definition

So what is short selling? How do you sell a stock that you don't own?

How do you explain this to someone who is unfamiliar with trading?

Simply put, the stock broker lets you borrow you the stock from an original owner, and then you sell the stock, and the value of the stock is put into your account. However, at a later date you are obligated to buy the stock back (known as 'cover') and give back the stock to the original owner. After this happens, the original owner is no different in that they still own their stock. The stock broker makes a commission on the sales. And you as the short seller have either made a profit or loss depending on your sell and buy (cover) price.

It's like there are 3 parties involved, but in this more complicated way. The definition of short selling can be simple when thought of in this way.

Short Trading Ban 2008-2009

In the middle of the global financial crisis of 2007-2010 there was a temporary ban on short selling in the US, UK and Australia among other countries in an attempt to control spiralling downward prices in stocks.

The ban also affected the list of shortable CFD stocks and shares even though they were derivatives of underlying sotck market products. This makes sense as if stocks or CFDs are falling fast, more and more people shorting the stock or CFD (that is, selling the stock) will cause more selling pressure which lowers the price of the stock even more.

In an effort to control this, short selling was temporary disallowed.

What Are The Short Trading Strategies?

So how do you profit from short trading. There are several short trading strategies available for stocks and CFDs.

The first is trend following short systems.

These particular short trading strategies rely on the premise that shares that have been trending down for a while, are likely to continue trending down. The key in these systems is to have a trading condition that selects the stocks that will continue to trend down for longer. The condition used the the US or UK or Australian market may be different as stocks behave differently in these markets. If they are long term short, or short term short, will determine how many trades are triggered and consistency of the system.

The second is mean reversion short systems.

A stock that is going up abruptly, may be more likely to revert back to the mean or fall in price after this unusual volatile period of going up. Basically it is the opposite of a mean reversion long system, where a stock that dips abruptly may bounce back to its mean. These systems rely on finding suitable stocks that are tending up, then going up more than usual using a series or variety of displacement measurements, then picking an entry point to short, then an exit when the price falls.

The third are reversal systems.

These are a combination of long and shorts trategies in one. When a stock is going up the direction of trades is long, but when the moving average, other indicator or price action signals a potential downtrend, and/or there is a valid signal to go short, then you go short. These systems are really systems that go in either direction based on more short term moves in the stock prices rather than the longer term moves in trend following systems.

The fourth are hybrid systems.

These stock or CFD trading strategies are based on the condition that as the stock market in general is trending up over the medium term, as is the trend of the stock, then the direction of trades is long. If the market turns into a bear market, then the whole system turns short and you start to look for short trades. It could even look at an economic indicator such as official cash interest rates to determine the overall direction of the market. It is similar to the reversal systems, but looks more at the overall market as well to decide if the system is long or short for now.

Special Notes About Short Trading

Here are some points about short trading CFDs or short trading shares that you should be aware of.

First is that you should check the commission or brokerage fees for short selling shares. They may differ from that of long trades or may be the same. Fees do vary greatly between providers or brokers.

Secondly, the margin requirement for shorting may be different to that of going long. Again this depends on your broker or provider but take this into account when trading or backtesting.

Thirdly, the list of shortable shares can and do change from time to time. The ban on short delling recently is unusual and not common, but even outside this situation, the list of shares or CFDs that you can short varies with each broker. So check out these lists when when backtesting and not just assume that the top 100, 200 or other list of stocks in an exchange can be all shorted.

Why Trade Short?

So short selling, which is a way of profiting from falling prices, is often used as a part of an over combined trading stratgey that has both long and short.

Why? To smooth out equity curves and to have your overall system not fall down when the market turns and goes down. So the aim of a short system is to not lose when the market is rising and to make profits when it falls.

Some people use both a mean reverting and trend following short trading system that takes short trades in bull and bear markets respectively, to cover both directions of the market to give more consistent returns.