- Ignoring Market Trends
- Failing to Set Stop-Loss Orders
- Overleveraging Positions
- Neglecting to Monitor Margin Requirements
- Holding Shorts Too Long
Ignoring Market Trends
For instance, GDP growth rates, unemployment rates, or inflation can give a sense of market trends. A rising unemployment rate is one economic indicator of economic downturns, which could lead to falling stock prices. These metrics provide the short seller with food for thought. For instance, after the 2008 Financial Crisis, the peak US unemployment rate was 10%, which represented a severe economic contraction and a large decrease in stock prices.
Monitoring Market Sentiment
There are numerous ways to assess market sentiment, such as investor surveys, social media conversations, and news reports. For example, market sentiment became significantly affected by social media platforms like Reddit during the GameStop short squeeze in January 2021. Those short sellers who neglected this sentiment were wiped out as the stock soared from about $20 to $300+ in a matter of weeks.
Using Technical Analysis
Technical analysis analyses historical market data such as price and volume to forecast future price movements. Indicators such as moving averages, Bollinger Bands, and the RSI are useful in determining the direction of a trend and potential turning points. For instance, a stock consistently trading below its 50-day moving average and in the midst of a negative RSI trend can be classified as bearish and thus optimal for short-selling efforts.
Sector and Industry Trends
Not every sector or industry will respond in exactly the same fashion to economic fluctuations. For example, when international travel grinded to a halt due to the COVID-19 pandemic, everything went south for airlines and hospitality. By the time these dynamics were visible, many short sellers had taken positions in the stock prices of companies such as American Airlines and Marriott as they were pointing down.
Historical Data and Patterns
The study of historical data is crucial as it often repeats itself over the period, showing earlier patterns of prices. An example of this is that certain stocks may have recurring seasonal trends: think of retail stocks that are in favor before the holidays, while they are sold after. Based on this historical data, a short seller can argue to time their short more effectively. For example, shorting retail stocks in January, after the holiday season, could be a strategic decision supported by historical evidence.
Failing to Set Stop-Loss Orders
A stop-loss order is an order placed with a broker to sell a security when it reaches a certain price. To automatically sell when a stock hits a specific price, the stop-loss order will make a market order to sell the stock. For example, if you short sell a stock at $50 but place a stop-loss order at $55, your position will automatically be exited if the stock price jumps to $55 — meaning your loss per share would be capped at $5.
Why You Must Always SET Your Stop-LOSS_ORDERS
Stop-loss orders are important because they guard you against sudden and unforeseen market moves. Tesla Stock Soars In 2020, Burns Short Sellers. Tesla Inc. quickly skyrocketed from $200 to over $800 in the course of a year, and short sellers who didn’t have stop-loss orders in place fell prey to some of Tesla’s losses.
How to Implement Stop-Loss Orders
Know Your Risk Tolerance: Establish your accommodative loss while running a short position. The cost is typically a percentage of the share price (the company may also receive a fixed dollar amount of shares, or the employee may have the option to purchase the shares in a second contract).
Stop-Loss Price: Your stop-loss is your risk tolerance. So you short a stock at $100 and you are willing to lose 10%: set your stop-loss order at $110.
Review Your Positions: Revisit your stop-loss orders periodically and modify them as needed to account for changes in your investment approach or market conditions.
GameStop Short Squeeze — A Case Study
The GameStop short squeeze, which commenced in January 2021, is an exemplar of why stop-loss orders are crucial. Retail investors working together to buy GameStop drove the stock from $20 to over $300 in the span of days. Suffice it to say, just as many short sellers who had no stop-loss orders in place suffered apocalyptic losses of their own. Melvin Capital, for example, as part of its short in GameStop, lost more than 50% of the assets under management.
Dynamic Stop-Loss Strategies
Trailing Stop-Loss Orders to Protect Profits and Limit Downside: A trailing stop-loss order modifies the stop price with an increase in the market price by a fixed percent or dollar amount. On a 10% trailing stop-loss: if you short a stock at $100, the stock goes to $90, the stop-loss order moves to $99. If the stock then proceeds to climb to $95, the stop-loss remains at $99, still sheltering some profits and likely preventing a loss on the trade.
Overleveraging Positions
We remind you that the use of overleverage on orders will lead to catastrophic losses. For example, short selling 1000 shares of $50 stock at 2:1 leverage would be the equivalent of controlling $100,000 worth of stock using $50,000 of your own money. With the stock at $60, the position is now worth $120,000 ($60 x 2,000), and you are $20,000 in the hole. This $20,000 loss amounts to $0.40 profit per share compared to $20,000 without leverage, and your return is only half of it.
CASE STUDY OVERVIEW — VOLKSWAGEN SHORT SQUEEZE
Volkswagen short squeeze: The frame of a financial bubble. Overleveraging in short selling is a particularly popular case, with the most damaging one being the Volkswagen short squeeze in 2008. A well-known framework for any financial bubble, Volkswagen was a favorite target for hedge funds looking to profit from falling stock prices, thanks to the high proportion of the company’s shares that were held as cash on long-term account. But then Porsche came out and said they had secured 74% of Volkswagen shares, and well, shorts were the ultimate hunted in this massive short squeeze. Volkswagen shares almost quadrupled, from around €200 to over €1000 in the space of days. Massive losses were incurred in the hedge funds that were over-leveraged, with some losing several billion euros.
Managing Leverage
Evaluate Your Risk Tolerance: This is how much you are willing to risk. If, for instance, you have $50,000 to invest, you can limit your overall leverage to 1.5:1, giving you $75,000 of stock-control power.
Maintain Strict Margin Requirements: Have plenty of available margin to cover yourself from potential losses. For example, set the base margin of 30% so that you will have at least 30% of the total position equity. This event will trigger a margin call if your account goes below this mark.
Implement Stop-Loss Orders: Use stop-loss orders to reduce the downside. So, for example, you may short sell a stock at $100 with the stop-loss order set at $110. If the stock price goes up to $110, the position will close by itself, so your worst-case scenario is $10 a share.
Dynamic Leverage Management
Leverage is adjusted among traders depending on market conditions. Example: Lower leverage in times of high volatility to reduce risk. Contrarily, during stable market conditions, you might extend some prudence and raise leverage in return.
Note: Netflix Stock Volatility Example Short Netflix During A Rocky Earnings Season: For example, if the price of the 500 shares you’ve shorted is $300, and you have 2:1 leverage, then you are controlling $300,000 in stock with $150,000. Should a positive earnings report drive the price up to $350, then your position would now be worth $350,000 — a loss of $50,000. You would be out $25,000 had you used 1:1 leverage. It goes to show why managing leverage is important.
Neglecting to Monitor Margin Requirements
Margin requirements are the least amount of equity an account holder must keep in a margin account. In the case of short sales, this involves keeping collateral that is a particular percentage of the total value of the short position. In this case, your broker will post a margin call after the value of your account falls below this limit.
Margin Requirements — What Happens If You Ignore Them
If margin requirements are not kept adequate, you will get a margin call in which the broker will require more funds to cover the short position. Failure to meet the margin call would force your broker to liquidate your positions (often at unfavorable prices) in order to bridge that deposit gap. For instance, if you sell short 1,000 shares of stock at $50, the initial margin requirement might be 150%, or $75,000. In this high-growth stock, your short position has increased in value from $30,000 to $60,000, but the same is true in the case of your required margin — which means you may get a margin call if you do not have enough equity in your account.
AMC Entertainment Short Squeeze Case Study
The AMC Entertainment short squeeze happened in 2021, resulting in a rising stock price that went from ≈$2 to ≈$20 within a few weeks, causing many short sellers to receive margin calls. Short sellers who did not manage to keep in touch with their margin were unable to execute their mandates and literally blew up at higher costs than what they sold to, meaning they lost a lot of money. When the stock started to plummet, some hedge funds, like Melvin Capital, were forced to make billions in losses and were forced to liquidate.
How to Keep an Eye on Margin Requirements
Review Margin Account Often: Go through your margin account on a daily basis to make sure you have the necessary equity amount to satisfy the requirement.
Calculate Potential Margin Calls: How spikes/drops in stock prices can impact your margin requirements. Find the extra margin required if a $100 stock increases by $10, $20, etc., while short-selling with 150% of margin requirements.
A Buffer: Extra funds or securities in your margin account provide a buffer in case unexpected price movements occur. In this scenario, having an extra $10,000 on top of a $75,000 margin requirement can cushion against the occasional price spikes.
Configure Alerts: Make alerts provided by the broker notify you when your account is close to the minimum margin requirement.
Example: Tesla Stock Volatility Think about shorting Tesla with all of its wild price swings in 2019. Your initial margin is $105,000 if you short sell 500 shares at $700 with a 150% margin requirement. If the value of Tesla rises to $800, the short position is worth $400,000, so the required margin is $120,000. If you do not keep track of this increase, you will be subject to a margin call, which means you will need to put in $15,000 more into your account, or face getting liquidated.
Holding Shorts Too Long
When you have a short position from a long time back, first you take on the risk of turning the market around, a strong company news or overall market direction. So if you shorted Tesla at $400 in 2020 thinking it was going to fall, you would have been down an extraordinary sum as the stock ran up to well over $800.
Setting Clear Exit Strategies
Give Targets: Pop your buy zone and sell those bids but also determine where you think shorts will hit their bottom. So, for instance, if you short sell a stock at $100, you may aim to buy the stock back at $80. This presents the best of all worlds, serving as a defense against human nature to always try to stay in for extra large gains.
Trailing Stop Orders: Set up trailing stop orders to exit the trades at a profit and capture the potential upside. So, for instance, if you sell short a stock at $100 and it falls to $90, a trailing stop order set at 10% would then automatically move your stop price to $99. If the stock happens to go back up in price, your stop would be guaranteeing profits.
Monitoring Market Conditions
Stay Updated on Market Trends & Short Triggers: One example is that if you watched Reddit forums during the 2021 short squeeze of GameStop, you would have known to cover your shorts early and prevent the rapid rise in the price. The stock rose from about $20 to over $300 in a matter of weeks, leading to heavy losses for short holders who had not covered soon enough.
Using Technical Analysis
These overbought conditions can present potential reversal points that technical analysis may help identify. Various technical indicators such as the Relative Strength Index (RSI) and moving averages can help signal when a stock could be poised for a trend reversal. One example is when a stock’s RSI falls below 30; this may indicate that a stock is oversold, and in this scenario, that the stock could soon see a turnaround.
Netflix Earnings: Given the unpredictability of the last few months, more info is necessary. Netflix’s revenue was up 24.1% from the same quarter the previous year.
Short Netflix Prior to an Earnings Announcement: Example: If Netflix is at $500 and you expect their earnings to be worse than the Wall Street consensus, you could place money on the stock to move lower (you would short the stock). But if Netflix surprises the market with earnings results that were better than expected, and the stock goes through $550 to the upside, keeping your short position may become a never-ending losing proposition. One solution to these risks might be to use a trailing stop order or establish a hard exit at $525.
Positions are Monitored and Adjusted as Appropriate
Review Regularly: Schedule times when you will go back over your short positions and tweak them as needed based on what the market is doing or anything new you have learned.
Change According to News and Events: Be ready to adjust your short positions as long as there are significant news or events on the way. However, if the company announces a product launch or receives a favorable analyst upgrade, or another factor that might cause the shares to rise, you should consider covering your shorts to save yourself from losses.
A Case Study: The Product Announcements of Apple
For example, if you short sell Apple at $150, expecting a market correction soon, and then Apple announces a hotly-anticipated product which causes a rally, the stock will probably spike. In this case, an initial target exit as low as $140 will give you a chance to get out (upgrade the target as you see the price movement) and include trailing stop losses to help you avoid holding the short too much and saving a huge loss.
