Is short selling a good hedging strategy during overzealous market conditions?
Short selling can be a good strategy to hedge, but you have almost unlimited downside.  If a stock price skyrockets, you may be forced to cover your short by the brokerage before you want to or put up more capital. A smarter strategy to hedge, that limits your potential downside is to buy puts if you think the market is going down.  Your downside is limited to the total amount that you purchased the put for and no more. Another way to hedge is to SELL calls that are covered because you own the shares the calls refer to.  You might do this if you thought your stock was going to go down but you didn't want to sell your shares right now.  That way the only downside if the price goes up is you give up your shares at a predetermined price and you miss out on the upside, but your downside is now diminished by the premium you were paid for the option. (You'd still lose money if the shares went down since you still own them, but you got paid the option premium so that helps offset that). The problem with short would be that even if the stock eventually falls, it might raise a lot in the meantime, and unless you have enough collateral, you may not survive till it happens.  To sell shares short, you first need to borrow them (as naked short is currently prohibited in US, as far as I know). Now, to borrow you need some collateral, which is supposed to be worth more that the asset you are borrowing, and usually substantially more, otherwise the risk for the creditor is too high. Suppose you borrowed 10K worth of shares, and gave 15K collateral (numbers are totally imaginary of course). Suppose the shares rose so that total cost is now 14K. At this moment, you will probably be demanded to either raise more collateral or close the position if you can not, thus generating you a 4K loss. Little use it would be to you if next day it fell to 1K - you already lost your money!  As Keynes once said, Markets can remain irrational longer than you can remain solvent. See also another answer which enumerates other issues with short selling. As noted by @MichaelPryor, options may be a safer way to do it. Or a short ETF like PSQ - lists of those are easy to find online. "Point of order: ""What goes up must come down"" refers to gravity of terrestrial objects below escape velocity and should not be generalized beyond its intent.  It's not true that stocks MUST come down just because they have gone up.  For example, we would not expecting the price of oil to come down to 1999 levels, right?  Prices, including those of stocks, are not necessarily cyclical. Anyway, short selling isn't necessarily a bad idea.  In some sense, it is insurance if you have a lot of assets (like maybe your human capital) that will take a dive when the market goes down.  Short selling would have lost a lot of money in your case as the stock market between 2011 (when you wrote the question) and 2014 (when I wrote this answer) performed very well.  On average the long side stock market should make money over long periods of time as compensation for risk and the short side should lose money, so it's not a good way to make money if you don't have an informational advantage.  Like all insurance, it protects you against certain calamities, but on average it costs you money." "Below is just a little information on short selling from my small unique book ""The small stock trader"":  Short selling is an advanced stock trading tool with unique risks and rewards. It is primarily a short-term trading strategy of a technical nature, mostly done by small stock traders, market makers, and hedge funds. Most small stock traders mainly use short selling as a short-term speculation tool when they feel the stock price is a bit overvalued. Most long-term short positions are taken by fundamental-oriented long/short equity hedge funds that have identified some major weaknesses in the company. There a few things you should consider before shorting stocks: Despite all the mystique and blame surrounding short selling, especially during bear markets, I personally think regular short selling, not naked short selling, has a more positive impact on the stock market, as: Lastly, small stock traders should not expect to make significant profits by short selling, as even most of the great stock traders (Jesse Livermore, Bernard Baruch, Gerald Loeb, Nicolas Darvas, William O’Neil, and Steven Cohen,) have hardly made significant money from their shorts. it is safe to say that odds are stacked against short sellers. Over the last century or so, Western large caps have returned an annual average of between 8 and 10 percent while the returns of small caps have been slightly higher.  I hope the above little information from my small unique book was a little helpful! Mika (author of ""The small stock trader"")" "I saw that an answer hasn't been accepted for this yet: Being bearish is a good hedging strategy. But being hedged is a better hedging strategy. The point being that not everything in investments is so binary (up, and down). A lot of effective hedges can have many more variables than simply ""stock go up, stock go down"" As such, there are many ways to be bearish and profit from a decline in market values without subjecting yourself to the unlimited risk of short selling. Buying puts against your long equity position is one example. Being long an ETF that is based on short positions is another example." Right, wrong or indifferent I see account gains of nearly 50% so far this year; now being January 23, 2016.  That is  mostly staying on the short side.  I am not adverse to long positions at all; only hop to the other side when the tide turns. I will probably end up castrating myself on the fence at some point.
Don't sell. Ever.  Well almost. A number of studies have shown that buying equal amounts of shares randomly will beat the market long term, and certainly won't do badly.  Starting from this premise then perhaps you can add a tiny bit extra with your skill... maybe, but who knows, you might suck.  Point is when buying you have the wind behind you - a monkey would make money. Selling is a different matter. You have the cost of trading out and back in to something else, only to have changed from one monkey portfolio to the other. If you have skill that covers this cost then yes you should do this - but how confident are you? A few studies have been done on anonymised retail broker accounts and they show the same story.  Retail investors on average lose money on their switches. Even if you believe you have a real edge on the market,  you're strategy still should not just say sell when it drops out of your criteria.  Your criteria are positive indicators. Lack of positive is not a negative indicator.  Sell when you would happily go short the stock.   That is you are really confident it is going down. Otherwise leave it. Overvalued does not mean an opportunity to short.  As long as a company's earnings are decent and there are limited other opportunities in the market, a stock would stay overvalued. its just that future returns on the stock might be limited. For shorting you need an expected trigger. Say you expect an overvalued company's earnings to decline or significantly miss expectations. This would be a candidate for shorting.. "This doesn't make sense to me. Writing a covered call gives him a long delta position - the exact opposite of what he wants. And the tax losses won't turn a losing position into a winning one.  Is there something I'm missing?  Edit: Also, doesn't ""shorting against the box"" mean he has to have a long position, and short against that? That means you've got zero net delta, which isn't very useful at all..." It's actually quite simple. You're actually confusing two concept. Which are taking a short position and short selling itself. Basically when taking a short position is by believing that the stock is going to drop and you sell it. You can or not buy it back later depending on the believe it grows again or not. So basically you didn't make any profit with the drop in the price's value but you didn't lose money either.  Ok but what if you believe the market or specific company is going to drop and you want to profit on it while it's dropping. You can't do this by buying stock because you would be going long right? So back to the basics. To obtain any type of profit I need to buy low and sell high, right? This is natural for use in long positions. Well, now knowing that you can sell high at the current moment and buy low in the future what do you do? You can't sell what you don't have. So acquire it. Ask someone to lend it to you for some time and sell it. So selling high, check.  Now buying low? You promised the person you would return him his stock, as it's intangible he won't even notice it's a different unit, so you buy low and return the lender his stock. Thus you bought low and sold high, meaning having a profit. So technically short selling is a type of short position. If you have multiple portfolios and lend yourself (i.e. maintaining a long-term long position while making some money with a short term short-term strategy) you're actually short selling with your own stock. This happens often in hedge funds where multiple strategies are used and to optimise the transaction costs and borrowing fees, they have algorithms that clear (match) long and short coming in from different traders, algorithms, etc. Keep in mind that you while have a opportunities risk associated.  So basically, yes, you need to always 'borrow' a product to be able to short sell it. What can happen is that you lend yourself but this only makes sense if: First I would be very careful using a short ETF.  There could be some serious tracking error, especially if its levered.  Second, when it comes to forex you are in the world of PIPS and high leverage.  You would need to have significant capital to be able to hold out the swings as banks do their interventions.  Plenty of people have been short waiting, and waiting, and waiting, unless you think you know something the market doesn't this seems like a pretty high risk strategy.  I'd suggest buying options instead, but they will be expensive given the volatility. Thanks for your reply. I’m not familiar with the term “Held-For-Trading Security”. My securities are generally held as collateral against my shorts. To clarify, I am just trying to track the “money in” and “money out” entries in my account for the shorts I write. The transaction is relatively straight forward, except there is a ton of information attached! In simple terms, for the ticker CSR and short contract CSRUQ8, the relevant entries look something like this: There are no entries for expiries. I need to ensure that funds are available for future margin calls and assignments. The sale side using covered calls is as involved. "The margin rules are also more complicated.  A simple buy on a non-margin account will never run into margin rules and you can just wait out any dips if you have confidence the stock will recover.  A ""simple"" short sell might get you a call from your broker that you have a margin call, and you can't wait it out without putting more money in.  Personally I have trouble keeping the short sale margin rules straight in my head, at least compared to a long sale. I got in way over my head shorting AMZN once, and lost a lot of money because I thought it was overvalued at the time, but it just kept going up and I wanted it to go down.   I've never gotten stuck like that on a long position." There are rules that prevent two of the reactive measures you suggest from occurring. First, on the date of and shortly following an IPO, there is no stock available to borrow for shorting. Second, there are no put options available for purchase. At least, none that are listed, of the sort you probably have in mind. In fact, within a day or two of the LinkedIn IPO, most (all?) of the active equity traders I know were bemoaning the fact that they couldn't yet do exactly what you described i.e. buying puts, or finding shares to sell short. There was a great deal of conviction that LinkedIn shares were overpriced, but scant means available to translate that market assessment into an influence of market value. This does not mean that the Efficient Markets Hypothesis is deficient. Equilibrium is reached quickly enough, once the market is able to clear as usual. "He sold at 25 cents per pound and then as the price rises, the cash he has will buy less and less which could trigger a margin call as you are missing the ""short"" part of his position which is rather important here. From Investopedia: A margin account also allows your brokerage firm to liquidate your   position if the likelihood that you will return what you've borrowed   diminishes. This is part of the agreement that is signed when the   margin account is created. From the broker's perspective, this   increases the likelihood that you will return the shares before losses   become too large and you become unable to return the shares. If you sold at 25 cents per pound and the price goes up, at some point you may be forced to buy to cover the position as brokers don't like to lose their money. As another example of a short going bad, ""Devastated"" Trader Crushed By Soaring Biotech, Starts Online Begging Campaign To Fund $106,000 Margin Call notes in part: However where this story gets abusrdly entertaining, or woefully   tragic, depending on one's perspective, is that one trader, Joe   Campbell, was on the wrong side of last night's massive surge. As the   RutRho blog, which noticed it first explains, a ""dummy"" E-trader, Joe   Campbell, decided to go $35,000 short KBIO ""and now owes $ETFC a   wonderful $106K.""" The Art of Short Selling by Kathryn Stanley providers for many case studies about what kind of opportunities to look for from a fundamental analysis perspective. Typically things you can look for are financing terms that are not very favorable (expensive interest payments) as well as other constrictions on cash flow, arbitrary decisions by management (poor management), and dilution that doesn't make sense (usually another product of poor management). From a quantitative analysis perspective, you can gain insight by looking at the credit default swap rate history, if the company is listed in that market. The things that affect a CDS spread are different than what immediately affects share prices. Some market participants trade DOOMs over Credit Default Swaps, when they are betting on a company's insolvency. But looking at large trades in the options market isn't indicative of anything on its own, but you can use that information to help confirm your opinion. You can certainly jump on a trend using bad headlines, but typically by the time it is headline news, the majority of the downward move in the share price has already happened, or the stock opened lower because the news came outside of market hours. You have to factor in the short interest of the company, if the short interest is high then it will be very easy to squeeze the shorts resulting in a rally of share prices, the opposite of what you want. A short squeeze doesn't change the fundamental or quantitative reasons you wanted to short. The technical analysis should only be used to help you decide your entry and exit price ranges amongst an otherwise random walk. The technical rules you created sound like something a very basic program or stock screener might be able to follow, but it doesn't tell you anything, you will have to do research in the company's public filings yourself. Yes, just set aside the amount of money. If you buy a cfd long in a stock for a 1000$, set aside 1000$. If you buy a cfd short, set aside the same amount and include a stoploss at the value at which the money is depleted. In this case however, you can stil lose more, because of opening gaps. By doing this, you replicate the stock return, apart from the charged interest rate. "First, I would like to use a better chart.  In my opinion, a close of day line chart obscures a lot of important information.  Here is a daily OHLC log chart:  The initial drop from the 1099.23 close on Oct 3 was to 839.8 intraday, to close at 899.22 on Oct 10.  After this the market was still very volatile and reached a low of 747.78 on Nov 20, closing only slightly higher than this.  It traded as high as 934.70 on Jan 6, 2009, but the whole period of Nov 24 - Feb 13 was somewhat of a trading range of roughly 800-900.  Despite this, the news reports of the time were frequently saying things like ""this isn't going to be a V shaped recovery, it is going to be U shaped.""  The roughly one week dip you see Feb 27 - Mar 9 taking it to an intraday low of 666.79 (only about 11% below the previous low) on first glance appears to be just a continuation of the previous trend.   However... The Mar 10 uptrend started with various news articles (such as this one) which I recall at the time suggested things like reinstating the parts of the Glass–Steagall Act of 1933 which had been repealed by the Gramm–Leach–Bliley Act.  Although these attempts appear to have been unsuccessful, the widespread telegraphing of such attempts in the media seemed to have reversed a common notion which I saw widespread on forums and other places that, ""we are going to be in this mess forever, the market has nowhere to go but down, and therefore shorting the market is a good idea now.""  I don't find the article itself, but one prominent theme was the ""up-tick"" rule on short selling: source From this viewpoint, then, that the last dip was driven not so much by a recognition that the economy was really in the toilet (as this really was discounted in the first drop and at least by late November had already been figured into the price).  Instead, it was sort of the opposite of a market top, where now you started seeing individual investors jump on the band-wagon and decide that now was the time for a foray into selling (short).  The fact that the up-tick rule was likely to be re-instated had a noticeable effect on halting the final slide." "It is possible and it depends on your strategy. As short selling interest rates are annual and levied monthly at a prorated rate. Interest rates are also low in general, with the exception of hard to borrow stocks. Therefore you can maintain a short position for weeks on end and notice nothing. Months even, if the position itself has already gained in your favor. There is no additional fee for opening the short position. Although some brokers have a ""locate"" fee, if it is hard to borrow the stock and they need to go find some shares to short. So you can do it as much as you like." I'm not saying I'm so sure as to start shorting tech stocks (with market volatility what it is nowadays, you could lose money because bankers got a bailout and everything went up irrespective of its actual earnings).  But I'm so sure as to say that selling any stock you've got in small tech companies and avoiding investing in start-ups is probably a good idea. The problem with short options is they expire and have to be covered. An inverse ETF is the way to go in my opinion. Because the real issue isn't if the market is overvalued but when will it correct. That's the risk and no one knows that answer