Before we begin, please note that nothing in this post is financial advice but is for educational purposes only.
It is fair to say that most investors tend to go for long positions rather than short. With long positions, an investor buys at one price and sells at a higher price. It feels quite natural and indeed it is.
Taking a short position involves increased financial risk and there are arguably more factors to take into account. That said, in bear market conditions, taking a short position could be a prudent move, and depending on world events, shorting in the futures market can yield good results.
What is a Traditional Short Position?
The principle of a short position is that you’re betting the price of a certain stock, commodity or currency will fall.
For example, you decide that an underlying asset price will go down. It could be you expect a price correction as it is currently overpriced, or you feel there are global factors that will dictate the price drop.
Whatever, the reason, you take a short position in which you borrow from a broker the asset you wish to trade. You sell the asset at the current price. For the sake of this example, its total value is $5000. Should the price drop to $4500, you can buy the asset at that price, return it to your broker and make $500 profit.
The risk comes in the form of margin. This is where you borrow the asset to sell in the first instance. As such, there are interest charges to take into account and this can negatively affect returns. This is known as marginal trading.
It is important to bear in mind, that margin can amplify gains, but also amplify losses.
In the futures market, margin works a little differently. As futures trading is leverage by design, the margin is the amount of money it requires to open a short or long position rather than a loan. There are high risks with this system, and losses can be unlimited.
What is a Futures Short Position?
Although the principle is the same there are key differences in shorting Futures such as you do not need to borrow shares from a broker to open a short position. You also have no time limit. Traditional short positions tend to have a time limit of one day.
This is because, in a futures contract, you do not own shares or stock. Instead, it is a financial contract between parties that provides exposure to the whole market.
If you were to buy two ES futures contracts, you would have to outlay the same amount of margin as if you were taking a long position. So 2 x $600 = 1200. Now, for every point the S & P falls you gain $100 in profit. The reverse is true every time the S & P increases.
When to Short?
In terms of long vs. short, both have their place. Let’s take a deep dive into when it is a good idea to take a short position in futures.
Investors that go for the short position will be looking at commodities and the like, closely trying to spot a downward trend. As well as the basic trendline, many look at the moving average to try and spot a price decline.
Other aspects they look into include:
- Profit forecast not as good as expected– Should a company give a profit forecast that falls short (no pun) of what is expected, this can see prices taking a hit. In this case, investors will take short positions hoping to exploit the opportunity.
- Sector is in decline– As we saw from the recent lockdowns some sectors strengthened while others went into decline. Savvy investors moved quickly to short positions based on the trends that emerged. It doesn’t have to be anything extreme as locking down to take a short position, but certain sectors are going to do better than others when you factor incoming legislation such as Environmental Social Governance (ESG) into the equation.
- Seasonal Occurrences– Aspects such as tax loss selling and insider moves are other times when it could be prudent to take a short position. This kind of occurrence tends to hit price quite hard and as such, short position opportunities arise.
- Price correction– Sometimes, commodities, currencies etc, see meteoric price rises as investors try and get in on the action. As price pumps come to an end, an inevitable price correction will follow. Again, this presents an opportunity to go short.
- Federal Reserve– Read any financial news article and due to the current state of the world, nearly every financial trader worth their salt is eagerly listening out for announcements from the chairman, especially on the topic of inflation that has been in an upward trend for some time now. The simple fact is that together with various reports such as the jobless report influence the markets considerably.
High inflation results in lower share prices generally while low inflation gives investors confidence in the economy and as such, investment. In essence, as the U.S. dollar is the world’s reserve currency, what happens in the Federal Reserve has impacts worldwide.
Going short is viable providing you know what you are doing. So take the time to explore the technical side of things and make sure you understand the risks.
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