Strategy and Risk of going short, Analyzed.

Lets talk about trading and shorting:

I will first go over basic concept of shorting (feel free to skip ahead if you already know), its risk involved, and why it is different from a traditional long position. Then, I will talk about short strategies and how hedge funds and traders use it.

Short concept explained:

Going short is essentially a bet that is profitable when price goes down. In order to short a stock or bitcoin, you must borrow the underlying asset from someone else. Instead of buy low sell high like a long position, you sell high buy low. So you sell the asset after you borrow. If the asset price drops, you profit because you can now buy it back for cheaper than you sold it for.

The risk for shorting compared to long:

  1. Markets price is negatively skewed; the fall is faster than the rise. The decline is fast and violent so timing the market for entry and exit becomes very important since timing window is narrow.
  2. Shorting has potentially unlimited loss. In reality, it’s likely your margin call requirement. That is why Bitfinex exchange offers insurance in the off chance that your loss is greater than the margin requirement.

It is very easy to understand the risk#2 because it is just math. However, the first risk is very difficult to grasp for a beginners. This is also subjective so it is best that I cover it with a few examples.

Examples

I've noticed today that some people want to short DRK since it is on the rise. My recommendation is: don’t try to short anything when it is going up. Wallstreet traders and hedge fund managers do not short stocks at the highs and they know the ins and outs of the game. How do I know this? You can easily look at the short float interest (kind of like BFXdata, BTC swaps) of any stock.

For example, which leadership stocks on S&P are making new highs? AAPL (Apple), and GS (Goldman Saches). What is the short float %? Less than 2%. Shorting at the top is essentially the same concept as catching the falling knife on the way down for longs.

What lagger stocks have very high short float? NFLX  (Netflix) and JCP (JC Penney), 10 and 30% respectively. If you look at their performance, they are making new lows!

In summary, going long on new low and going short at new high are dangerous. Don’t do it.

Let me know what you think about this post, I will probably post more examples in another. Bitfinex and OKCOIN allows you to have margin long and short including futures