Short selling is a way to profit when the indices or an individual stock declines. The mechanics can be a bit convoluted, but it isn't necessary to understand the complexities in order to make short sale trades.
Technically, when you short a stock, you borrow the targeted stock through your broker and then immediately sell it. The goal is to repurchase the shares eventually at a lower price and return the borrowed shares. If the stock drops sharply, you can make a nice gain when you rebuy the shares you borrowed at a lower price.
There can be difficulty borrowing stock at times, and your borrowed shares may be 'called' by the broker. Some short sellers avoid these problems by engaging in illegal 'naked shorting' when no actual shares are borrowed.
The borrowing of shares to short creates a very different dynamic than merely buying and can produce tremendous short squeezes like we have seen recently with GameStop (GME) . When shorts can't borrow any more shares, they are in danger of being caught in a short squeeze.
Inverse ETFs can also be used for short selling, which helps avoid some of the problems, but they are not available for individual stocks. Another alternative is options that provide more flexibility but carry very different risks.
The critical thing to keep in mind about shorting stocks is that it is not just the inverse of going long. Indices and stocks tend to decline much differently than when they go up. The most basic illustration of that fact is that rallies and uptrends last far longer than pullbacks and declines. Over the very long term, stocks will go higher. Bull markets have dominated the market action for the last century, while bear markets have been very abrupt and lasted just a relatively short amount of time.
Because bear markets and corrections are more sudden and don't last as long, timing short sales is much more complicated than timing market uptrends.
Traders that are effective at shorting tend to develop an entirely different mindset than traders that focus on the long side. The most significant difference is that short sellers need to be more anticipatory. Since selloffs tend to occur suddenly and end quickly, it is necessary to be in position very early if you are to catch the meat of a downside of the move. In contrast, long side buyers typically have much more time to catch upside momentum and can stay with trades longer as tops tend to take some time to form.
Highly reactive traders can catch good short sales if they move very fast, but most short sellers are anticipatory and are mentally prepared to be on the wrong side of the trade before it works. They will lose money and incur opportunity costs while they wait. If they wait long enough, the market's natural cyclical nature will eventually reward them, but the timing can be tough, and the costs of fighting the trend can be substantial.
The biggest problem that short sellers face is that it can take the market a very long time to recognize fundamental and valuation arguments. There are some stocks that short-sellers believe are outright frauds, but they continue to run higher. Names like Tesla (TSLA) , GXS Techedu (GSX) , and even GameStop have been identified as obvious shorts by sophisticated short-sellers, but the stocks refuse to relent. As the old saying goes, 'the market can remain irrational, longer than you can remain solvent,' which is especially so with shorts.
The appeal of short selling is obvious. When the target is right, and the timing is good, the gains can be quick and substantial. Stocks and indices always fall faster than they rise, and the appeal of profiting from that dynamic is great.
In my career as a trader I've never been an aggressive short seller. I find it too difficult to cultivate the necessary mindset for it and have difficulty shifting from my typical trading mindset for long trades to a more anticipatory mindset needed for short selling. When the market suffers a correction, I have found that I do better at trading counter-trend bounces rather than catch downside momentum. The biggest bounces always are produced in the worst market. I believe that most traders can do very well by focusing on long-only trading, and some can do well by focusing primarily on short selling.
One of my goals is to spend more time cultivating the mindset for some selective short-selling because it will help me better understand those on the other side of my trades. Traders should always be pushing to educate themselves and find new strategies to enhance their return. The first step in becoming adept at short sales is the adjustment in thinking that it requires. That is my challenge.
Once you recognize that short selling is not just the inverse of going long and understanding the adjustments that need to be made to your trading style, it can be a great tool, but it is not easy and carries a higher risk level.