Short selling is a very popular but risky trading strategy. As stock prices can move up and down, it is important to know when to short a stock. Here are 6 main reasons to help you decide to go short on a stock:
6 reasons to help you decide to go short on a stock
Technical analysis is the study of charts, momentum, and strength of the trend in any financial market. Trends often change from an uptrend to a downtrend, based on key technical indicators. A few of them are moving averages, or trendlines. Most traders monitor popular momentum indicators, such as 100-day, 50-day, and 200-day moving averages. When a stock is trading below some of all these moving averages the trend has changed from an uptrend to a downtrend and a descent for a stock price is likely.
The SEC (securities and exchange commission) requires certain individuals who hold a substantial amount of stocks in any publicly-traded company to fill frequently forms 3, 4 and 5. These forms are published at frequent intervals. At times when there is no specific news related to a stock, these forms can be an early signal that there could be a specific reason these insiders are selling the stocks. Then maybe you should go short sell these stocks.
The bond yield curve
Bonds are safe financial assets, and this implies a rather small return. Stocks are riskier financial assets.
There are times when external shocks, or an economic slowdown can cause an inversion of the yield curve for bonds.
These factors are not supportive for stocks, and at times of panic, traders tend to short sell stocks and turn to safer investments such as bonds.
Fundamental analysis is very important because it can highlight problems related to the financial performance of stocks and their valuation. A very good reason to go short on a stock is when there is a deterioration of its fundamentals.
Declining financial ratios, such as profitability, gross margins, and net margins, an increasing amount of debt, declining revenue, are all major reasons that could support your financial analysis to short sell a stock.
Fundamental analysis can help also discover whether the current valuation of a stock is justified or not.
If your financial analysis supports the idea that after a strong rally, a stock price seems overvalued and you get a confirmation from your technical analysis, this could a strong reason to start short selling this stock.
Any global economic recession on the horizon
Stocks tend to perform well when the economy is booming and perform very poorly when the economy is on the verge of a recession. With the most recent external economic shock, the global coronavirus outbreak, many investment firms have revised their estimates of growth. This happened both for the US economy and the global economy, and even mentioned the scenario of a global economic recession in 2020.
A very crucial economic indicator to monitor is personal consumption and spending. For the US economy personal consumption can attribute almost 70% to the GDP growth, so any sustained decline in personal consumption is set to have a negative impact on the US GDP growth.
At times of economic recession and even at an economic slowdown, going short on stocks can be justified both based on fundamentals and on technical analysis.
Specific stock news, financial and business news
Every three months during the release of the stock earnings for US stocks, there is a period of increased volatility for most stocks. This is another fundamental factor, as mentioned above. But monitoring stocks during this earnings period can provide a lot of useful information.
There are earnings misses, downgrades, specific economic news and finally a rotation both for stocks and sectors among major institutional investors.
What are bad economic news? A company which has missed earnings expectations, and its stock has been downgraded by some major investment firms or financial analysts. Furthermore if a company has announced that the future economic outlook is not so optimistic as in the past, then going short on its stock could be justified.
Going short on a stock conclusion
These 6 reasons for when and why to go short on stock can help you decide to make better investing and trading decisions. This is because a well-informed investor and trader should not hesitate to go short on a stock. This is because if he/she has made due diligence and has analyzed some or all the reasons we mentioned.
Whether you like technical analysis or fundamental analysis, their combination in analyzing stocks can be a valuable tool. As a result you can palce higher-probability trades on any financial markets. The decision to go short on a stock can improve your overall profitability in trading.
As a result, now it should be easier for you to decide when to go short on stock. Short selling is a trading strategy you can use especially now that financial markets plunge frequently due to the coronavirus outbreak.