Is This The Right Time To Start Short-Selling Stocks?

By the end of 2021, the stock market showed similarities to the dot-com bubble burst. Still, the extent of the latest down-movement was anything else but expected by market participants.

The SPDR S&P 500 ETF Trust NYSE fell from its all-time highs of $479.98 (January 4, 2022) to $437.98 (January 21, 2022).

Interest Rate Projection Triggered The Downward Spiral

The stock market is never rational and entirely predictable, but the extensive media appearance about interest rate hikes made it likely that the stock market will start a consolidation process soon.

Looking at the SPDR S&P 500 ETF Trust charts reveals two important things.

• The daily chart shows that the market is weak and even lost the support of the SMA 200. The dynamic is high, and it seems that more and more market participants cash in unrealized profits, which accelerates the downside momentum.

• The monthly chart clearly shows that the recent consolidation is small relative to the previous gains. The SPY gained from its lows at $218.26 in March 2020 to its all-time highs of $479.98. This equals a performance of +120% within 22 months. Within a 10-year range, the SPY was up about 270%. The uptrend is still intact from a long-term investing perspective, even if the market consolidates by another 20%-30% to the $320 - $340 range.

Pros and Cons of Short Selling Stocks In This Market Environment

Investors who have followed Netflix Inc. NASDAQ lately, likely have thought about the immense potential of short selling. In November 2021, Netflix hit its all-time-highs of $700.99 and the $1,000 seemed to be within reach. In December, the sentiment already shifted, and the first lower lows and lower highs were made. 

On January 20, 2022, Netflix reported weaker than expected guidance for new subscribers, and the price per share fell temporarily to $379.99. So, investors who sold shares of Netflix short at its highs made over 40% in under two months.

However, there are many things to consider before short-selling stocks.

The most important one is that investors have unlimited risk when short-selling stocks while buying shares only has the risk of the investment value.

Example Example 1: Buying 100 Shares of XYZ for $100

Szenario 1: Shares go to $500

Result of case 1: Profit = ($500-$100)*100 shares = +$40,000

Szenario 2 (worst case): Shares fall to $0

Result of case 2: Loss = ($0-$100)*100 shares = -$10,000

Example 2: Short-Selling -100 Shares of XYZ for $100

Szenario 1: Shares go to $500

Result of case 1: Loss = ($500-$100)*(-100 shares) = -$40,000

Szenario 2: Shares fall to $0

Result of case 2: Profit = ($0-$100)*(-100 shares) = +$10,000

(calculation: buying price - selling price * number of shares)

A short-seller sells first and has to buy back shares at some point later.

• An investor who buys the shares limits his potential loss to the total amount of the investment while he has unlimited profit potential for the long position.
• A short-seller limits his profit potential right from the beginning since the price per share can not fall below $0, but the risk is unlimited since the price per share can go anywhere to the upside.

Conclusion

Long-term investors have a higher probability of long-term success when buying stocks because the risk is exceptionally high for long-term short-sellers, especially if no stop loss is used.

The current market volatility can be beneficial for day traders to go long or short intraday. Still, it remains important to secure a position with a stop-loss since a sharp rebound can happen at any time.

Alexander Voigt is the Chief Executive Officer and founder of daytradingz.com. He does not hold any positions in the mentioned stocks.