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In our previous article of this series, we looked at short selling and how you can benefit from market downturns, instead of just moping about how things are all crashing down. But how do you actually figure out when you should short sell a security? And more importantly, how do you protect yourself against the huge risk that short selling presents?
We take a look at some of the more successful strategies here, as well as how you can make use of some risk management tools to trade smarter as well:
1. Entering within a trading range and waiting for a breakdown
A breakdown isn’t what happens when you realise you were trading blindly and lost all your money. Ok, maybe it is, but that’s not what we’re considering here since, you know, this is about being a smart investor.
Simply put, if you were to look at a trading range, which is the spread between the highs and lows of trading prices that have been traded within a given period of time, you will see what is known as a support level, which is the general average floor of trading prices within that period. It is important to know where the trading range is to better identify the support level and resistance level. The support level is usually identified as the price that the markets do not want the asset to fall below.
In the chart above, the support level of currency pair SGD/JPY is around 80. Hence, investors can look to this price to buy into the market. A breakdown is then the point where the prices breaks through that bottom support level and this is usually accompanied by sharp declines and as such is an opportune time to short sell.
Tip: Platforms like IG have alerts that allow you to identify when a security has hit a certain marker so that you can track to see if a breakdown is going to happen.
2. Selling into an Active Decline
When a security closes at a price lower than the opening price, a decline happens. Short selling into an active decline to make the most out of the situation is quite common, but you should also make sure that you are protected against any sudden upswings.
Especially when it comes to foreign currency markets, we’ve already seen this year how violently markets can swing, which does make it good for short selling, but also presents some risks to your short sell as well.
Tip: Use a Guaranteed Stop to protect yourself from sudden market movements. Not sure how effective they are? Check out our article on how they work and how traders can protect themselves.
3. Selling a Pullback in a Downtrend
A pullback is a short pause or a brief reversal in the general direction a security price is moving. The important thing to note here is that time is an important factor in the definition of a pullback, and a longer pause in movement before the upward trend continues is usually referred to as a consolidation.
Pullbacks are widely seen as buying opportunities after a security has experienced a large upward price movement. Why? Because you’re able to buy the security at a cheaper price, while still believing that the trend will continue upwards. Think of it as a flash sale of sorts.
However, it’s also important to note that it could also be a sign of a trend reversal as well, and this is really dependent on your time frame and frequency of trading. A trader looking at multiple pullbacks in a day could see things very differently from someone who just trades once a day and sees it as an actual reversal. Whatever the case, being smart about using alerts and stops can help you to both take advantage of market movements whilst still protecting yourself against massive losses.
How can you manage your risk better?
As we’ve mentioned before, part of the risk of short selling is the fact that you technically owe someone something. If you were to trade a Contract for Difference, you don’t really have to worry about that. But there is still a chance that things could swing against your favour quite suddenly.
Using stops is one way to keep your losses from escalating out of control, and also helps remove the need to perpetually monitor the markets. Platforms like IG provide an additional layer of security, called Guaranteed Stops, which acts like an insurance, ensuring that your positions close exactly where you want them to.
Conversely, you can also set limit orders to lock in your profits, as you never know how quickly things can shift. Being smart about using technology can help you to navigate volatile markets even if you aren’t some expert trader. If you are interested to find out even more about what you can do, IG has recently released an e-book in collaboration with Bloomberg that you can download for free here!
The information in this article is meant for informational purposes only and should not be relied upon as financial advice. Users may wish to approach a financial advisor before relying on any advice provided by the website to make any decision to buy, sell or hold any investment product.