Short selling has made its way into the mainstream in the last few years.
The Big Short followed the story of Michael Burry, and glamorized his ability to make billions of dollars as the housing bubble collapsed.
More recently, the Reddit forum punished a short seller of GME as they drove the stock price higher and villainized his fund.
But short selling is widely misunderstood as a trading strategy, and how it can increase your profitability in all market conditions.
In this article, I’ll focus on explaining how short selling in futures works.
Concept of Short Selling
First of all, let me start by summarizing the concept of short selling in general.
The idea is to borrow something you don’t own from someone else and then sell it. You will collect the money now, but you are short (missing) what you borrowed. You have to return it at some point. If you can buy it for cheaper later, you make a profit. If it costs more, you have a loss.
In the stock market, short selling can be explained with this example:
- You start by thinking the stock is overvalued.
- You then get your brokers to lend you shares that you do not own and sell them at the current market price.
- You receive the money from the sale but you cannot use it to buy other stuff – it is in a segregated holding.
- In the future, if the price of the stock drops you can buy it back cheaper and return it to the broker, and keep the difference as your profit.
- In the future, if the price of the stock increases, you will have to buy it back at a higher price (and take the financial loss) before returning the shares to your broker.
So why bother shorting when, on average, the stock market goes up more than it goes down?
When it comes time to shorting stocks, the risk is unlimited. This is because the share price can technically go to infinity. Meanwhile, the profit target is limited. The maximum return is if the stock goes to $0.
However, in the futures market, shorting is much easier to accomplish and can enhance your day trading profitability. Futures shorting is also cheaper and a more liquid market.
Let’s talk about this next.
Benefits of Shorting in Futures
The futures market is designed to provide liquidity to professional traders for managing their portfolio risk in equities and commodities.
Instead of having to find a stock that you like to buy, you can purchase the entire index as a whole. For example, the S&P500 index value is traded with the ES futures contract.
This is a big benefit to institutional investors and traders who want to either hedge their position or increase their exposure without having to buy 500 stocks individually.
Think of how expensive that would be both in commission and time to execute?
At any given moment in the futures market, there is a depth of willing buyers and sellers.
Here is an example of level two, also called market depth in the ES on November 8th, 2021 at 3:02 PM EST:
As you can see there are 18 willing buy limit orders at the 4,698.75 price. Meanwhile, there are 135 willing sell limits at the 4,699 price.
If you want to short an ES futures contract, you do not need to rely on the broker to lend you the shares from one of their client’s accounts. This is because futures are a derivative, a contractual obligation between two counterparties. You do not OWN anyone’s share of a stock company, you are gaining exposure to the entire market index.
If you wanted to short, all you would have to do is a pick level to sell the amount of quantity you want. For example, if you wanted to short 2 contracts of the ES, you would have to put down the same amount of margin as you would if you wanted to buy it.
If you want to learn more about futures margin, click here to read how margin works in futures.
At a $400 USD margin per contract, you would need $800 in your account to “short” two futures contracts.
Every one-point the SP500 drops would lead to a $100 profit on your short position. Alternatively, every point it goes up, it would generate the same loss.
Why do People Short Futures?
There are many reasons someone would want to short using futures.
Imagine you are a professional fund manager. In three days there is a giant news event that will move the market. You don’t know which way, it’s anyone’s best guess really.
So you decide to neutralize your long portfolio temporarily. What are you gonna do, sell billions of individual stocks and pay hundreds of thousands of dollars in commission fees? Only to have to buy them again in a few days?
This is when professional traders short the futures market, in order to hedge their long portfolios and offset losses for a temporary period of time.
Another type of market participant that shorts are speculative traders. These could be hedge funds looking to profit on the expectation of a market drop. Or it could simply be a proprietary trader at a firm looking to take advantage of a pullback on the bull trend.
No matter what the strategy or outlook, all that matters is that at any given moment there are willing buyers and sellers. They are all looking to execute their trades. Some trade with each other, and others against one another.
The best part about futures trading is that you can make money regardless of market direction, whether it is going up or down. In fact, downtrends happen faster and are often more profitable.
There is no better market in the world today trade for a living than equity index and commodities futures. However, it is important you are prepared with the right training and community.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.