5 key things about Short positions

For Newbies

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Short positions are a powerful tool for profiting when indexes or individual stocks decline. The mechanics of the process can be complex, but you don’t need to understand the complexities to make short trades.

Technically, when we open a short position, you borrow the target stock through a broker and then immediately sell it. The goal is to eventually buy back the stock at a lower price and return the borrowed stock to the broker. 

Going short creates a very different dynamic than simply buying. Limited supply can lead to a huge short squeeze.

1. Going short is not as simple as going long. Indices and stocks tend to fall much differently than they rise.  ;The most basic illustration of this fact is that uptrends last much longer than downtrends. In addition, there is a natural tendency for stocks to rise over time. The market will often bail an investor out of a bad long position if is patient, but that doesn’t work so well for short positions. Bull markets have dominated the last century, while bear markets have been very sudden and relatively short-lived.

2. Good shorting requires more precise positioning. Bear markets and corrections are usually much sharper and more intense. Short positions require a lot more precision than adding in an uptrend.

Traders who are effective at shorting tend to develop a completely different mindset than those who focus primarily on the long side. Traders can pick up good short positions if they move very quickly through the market environment, but most sellers try to get ahead of the market and are mentally prepared to be on the wrong side of a deal before it ends up working. 

They are willing to lose money while waiting for the position to go their way, so if someone is used to instant results, short trading can be extremely frustrating as things move against the macro trend. 

3. Don’t short on valuation. The biggest problem short traders face is that the market can take a lot time to recognize fundamental arguments and changes in valuations. As the old saying goes, the market can stay irrational longer than we can stay solvent. This is especially true with short positions.

Suppose we believe that a stock is overvalued and likely to fall, the best approach is to wait for some technical weakness to develop. Technical formations such as a double top or lower high after hitting resistance are key positioning moments, as they give a visual idea of where to place a stop loss and, therefore, easier to determine the level of risk. Top fishing short positions is not an optimal strategy because it does not provide enough information to use to determine position parameters.

4. Avoid names that have been aggressively bought during bull markets. For years, short traders have targeted Tesla. The stock has had some significant declines, but this further confused sellers who believed they had compelling fundamentals. The top names tend to be more exposed to short squeezes, but when market conditions change, then those high P/E stocks growth are usually some of the best names for short positions. Of course, the durability of these declines is significantly less, because the stocks of famous names are preferred even by those who know nothing about the market and investing. This creates perpetual support for these stocks, and even if there is a decline, it will likely be much shorter than that of lesser-known names.

5. We don’t have to be Short in bear markets to make money. For some traders it can be very difficult to cultivate the attitude, required for short trading. It is a challenge to move from a mindset that works for long positions to the more unpredictable mindset required for short trading.

When the market undergoes a correction, some traders are better off focusing on playing the inevitable oversold bounces of the countertrend instead of taking advantage of the downward momentum. The biggest bounces always happen in the worst markets . Shorting allows traders to be more active in adverse market conditions, but more action is not always the best move when things are challenging. Effective short positions can provide big profits very quickly, but like everything else in the market, if it were simple and easy, then no big money would be made. This requires considerable effort and cultivation of the right mindset.

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