Rules and Strategies for Profitable Short Selling (2024)

Short selling takes skill to capitalize on a market transitioning from higher to lower prices. The steep learning curve intimidates investors, leading them to avoid the tactic entirely, even in bear markets. But this classic strategy can be profitable during uptrends and downtrends as long as strict risk management strategies are followed and your timing is carefully managed.

Of course, it’s easier to profit from short sales in downtrends because,as Martin Zweigsays in his 1986 classic Winning on Wall Street, “the trend is your friend.” Despite the advantage, short sellers get targeted relentlessly in bear markets, trapped in violent squeezes that blow out the most carefully placed stop losses. This reality means that long-term profitability requires more than throwing money at a falling security.

Mastering short sales means keeping to some simple entry strategies, perfecting your timing, and defensively managing your risk. You should also adopt tactics to prevent getting caught in a short squeeze. The tactics offered below aren’t fool-proofbecause it’s typical for sellers to incur shock losses on occasion. The point is to lower the risk of the worstwhile being aggressive so you can ride prices to lower levels.

3 Short Sale Strategies

You can sell short at any time in a liquid market that hasn’t imposed certain restrictions. U.S. regulators long had an uptick rule that was eventually replaced with an alternative regulation in 2010. The Securities and Exchange Commission (SEC) limits short selling when a stock has dropped at least 10% in one day, but this is rarely a factor in deciding whether to sell short. The broker must have the security in inventory when you take a short position. When there isn’t the corresponding inventory and you short anyway, that’s called a “naked" short sale. At times, the practice can appear ubiquitous, but naked shorts are illegal almost everywhere that shorting is allowed.

Profitable short sellers tend to follow variations on three techniques:

• Selling a pullback in a downtrend: This is selling after a security has had a temporary rebound or pullback within an overall downward trend. You expect the downtrend to continue, leading to profits when it returns to falling.
• Entering within a trading range and waiting for a breakdown: This means initiating a short position while the stock fluctuates between two prices without a clear trend. You wait for a “breakdown,” a move below the range’s support level, which is the price that it tends not to fall below. This indicates the stock price might continue to fall, thus potentially making a short sale promising.
• Selling into an active decline: This involves short selling a stock during a well-established declining trend line in price. You’re looking to capitalize on the momentum of the downward trend, anticipating further decreases in price to profit from the short sale. This gets risky fast since the word is out about the stock, and others are moving in to short it, too, which could backfire if you’re caught with a rebound of the price given the demand.

There is, of course, a fourth possibility; some traders do sell short at new highs, thinking a security has risen too far. When shorts come up in popular TV series, for example, it’s this kind of trade that is depicted. Regardless, it’s a recipe for disaster because uptrends can persist longer than technical or fundamental analysis predicts. Your rational analysis can mean nothing. As the quote apocryphally attributed to the economist John Maynard Keynes goes, "The market can remain irrational longer than you can remain solvent." In fact, the large supply of weak-handed short sellers in strong uptrends provides rocket fuel for even higher prices. All it takes is a few upticks, which these traders start to cover, to trigger a cascade effect that can add many points in a relatively short time, imposing devastating losses.

Example of a Short Sale

Coca-Cola (KO) had a rectangular pattern on its daily chart between November 2022 and September 2023. The pattern's resistance was around $64.99, while the support level was $58.11. The formation of this trading range became evident with the second daily high in April 2023.

A trader with a bearish outlook on KO would wait for a short-selling opportunity, especially when the stock approaches the upper boundary and creates the rectangular setup. The trader could use the moving average convergence divergence (MACD) indicator to confirm if the chance has come to strike. A short position would be initiated after a negative MACD crossover, signaling bearish momentum.

Risk management is crucial in this strategy. The trader would likely put in a stop-loss order slightly above the rectangle's resistance level to limit potential losses. The trader would also
calculate an appropriate risk-reward ratio to determine the exit point for the trade. The trader closes the position to secure profits when the stock hits this predetermined limit. Conversely, if KO's price rallied and triggered the stop loss, the trade would exit at a loss.

Short Selling Rules

In the U.S., short selling is regulated by several rules to ensure market integrity and protect investors. Here are some of the key rules:

Regulation SHO

This is the primary regulation governing short selling in the U.S. It requires brokers to have reasonable grounds to think the security could be borrowed before allowing a short sale. This is known as the “locate” requirement. Regulation SHO also bans naked short selling, which occurs when an investor sells shares that have not been borrowed and haven't been otherwise secured.

The alternative uptick rule

The uptick rule, or Rule 201, restricts short selling to a price above the highest bid in the market when a stock has dropped at least 10% in one day.

Margin requirements

Investors must have a margin account to engage in short selling. The Federal Reserve's Regulation T requires that the margin account have at least 150% of the value of the short sale at the time it's initiated.

Reporting requirements

Large short positions must be disclosed to the SEC, and some information is publicly disclosed.

Short-selling rules outside the U.S.

Below are some of the key rules and regulations governing short selling in jurisdictions outside the U.S.:

• European Union: Traders must report significant net short positions to the relevant national authority. Also, national regulators can impose temporary bans on short selling when there's extreme market volatility.
• United Kingdom: The Financial Conduct Authority requires public disclosure of net short positions that exceed 0.2% of a company's shares. Additionally, short selling is restricted on certain financial stocks and during public offers.
• Australia: The Australian Securities and Investments Commission mandates reporting of significant short positions. Traders must also have a legally binding agreement to borrow the shares before beginning a short sale.
• Hong Kong: Like the U.S. before 2007, there is an uptick rule in Hong Kong: Short selling is only allowed at a price higher than the last traded security price.
• Japan: Short selling is generally not permitted at prices lower than the latest market price. In addition, large short positions must be reported to the Financial Services Agency.
• Canada: Its uptick rule permits short selling only when the last sale price was higher than the previous price. Additionally, daily reports on short positions are required for certain securities.

Short Sales Dos and Don’ts

Your short sale performance can be improved by following certain principles that lower risk while focusing attention on the most promising prospects. Note that chasing lower lows in a momentum strategy should be scrupulously avoided until the short seller has developed a skill set proven by bottom-line profit and loss. This is important because these positions usually get filled at the worst possible prices because of algorithmic front running.

1. Short rallies, not sell-offs

As a short seller, your primary objective is to steer clear of the mainstream crowd while strategically piggybacking on their emotional momentum to secure the best entry price. Opportune moments for short selling often present themselves during countertrend bounces since these enable you to learn the price levels at which other sellers are likely to re-enter their positions. However, there's an inherent risk; if the cohort of sellers outweighs the buyers who are speculating on any emerging uptrend, the security's volatility can swing against you.

2. Short the weakest sectors, not the strongest

Let other traders get vertigo rubbernecking at explosive uptrends, thinking the security is too high and must fall to earth, and losing money when it doesn't—at least in the short term. A better plan identifies weak market groups already engaged in downtrends and uses countertrend bounces to get on board. Surprisingly, these cases frequently have lower short interest than a typical hot stock, making them less vulnerable to squeezes.

3. Watch the calendar and avoid bullish seasonality

Short selling around holidays or during options expiration week can incur painful losses because those markets don’t follow natural supply or demand. For example, there’s lower liquidity, and psychological factors are in play.Also, avoid short sales in low volume conditions, following the old cliché to "never short a dull market."

4. Short confused and conflicted markets

Take short positions when major indexes pull against each other.These conflicts generate bearish divergences that set off sell signals when instruments sync up and point downward in unison. In addition, sellers can use relatively tight stops that keep losses under control if the alignment points upward.

5. Avoid big story stocks

Traders love to sell securities with colorful, if dubious, stories that dominate the financial press, thinking they’ve uncovered an instant moneymaker. However, such stories often attract a massive crowd. In turn, the security incurs high short interest, significantly raising the odds for vertical squeezes even in downtrends.

6. Protect against failed breakdowns

New downtrends face frequent tests and seeming reversals. It’s essential to clearly define your cover price—the price at which you plan to exit your short position—especially if the price goes back to the breakdown level. Putting in a stop-loss order is the most prudent strategy in this scenario. Make it automatic, not just a promise to yourself at a certain market price. That's because of willpower and the psychology of trading, but also because you don’t want to discover that when you need to take action, your smartphone battery has died.

A stop loss lowers your risk because it specifies a price at which the short position will be covered, limiting your potential losses. You can set the stop loss at a level that protects profits without exceeding the break-even point. This approach ensures that gains from favorable moves are not lost if the market direction changes unexpectedly. Plus, there’s little advantage in taking a loss after the position has moved into a profit, so the stop should be no higher than your break-even price.

The Bottom Line

Short sales can be beneficial in bull and bear markets. These benefits require adhering to your own strict rules of engagement for entering trades, staying vigilant, and managing risk to overcome the potential for short squeezes, among other threats.