Shorting is a good skill to add to your trading skillset, as it allows you to take advantage of a wider array of market conditions, and also increases the variety of strategies you can employ. There are many methods of shorting the market. The most common are:
- Buy put option
- Sell call option
- Sell via CFD
Buy Put Option
| Description | Purchasing the option to sell an asset at a certain price by a certain date |
| Characteristics | Breakeven point is a moderate distance away, thus probability of a trade being profitable is significantly lower than 50%. As downside is capped while upside is unlimited, the magnitude of wins are much larger than losses. |
| Typical win/loss pattern | Many small losses, few big wins |
| Preferred Market Conditions | Volatile environment where moves are relatively large, so that it is easier for you to reach breakeven point, and upside potential can be maximized |
| Pros | Highest profit potential, profits can be several multiples of capital invested. Losses for each trade are capped. |
| Cons | Highest risk, entire capital sunk in a trade can be lost. Value of option declines over time. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex. |
Sell Call Option
| Description | Selling the option to others so that they can buy an asset at a certain price by a certain date |
| Characteristics | Breakeven point (for the person buying your option) is a moderate distance away, thus the probability of a trade being profitable is significantly higher than 50%. As downside is unlimited while upside is capped, the magnitude of losses are much larger than wins. |
| Typical win/loss pattern | Many small wins, few big losses |
| Preferred Market Conditions | Stable environment where moves are relatively small, so that it is difficult for the person who bought your option to reach breakeven point, and the number of losses can be minimized |
| Pros | Option position will earn more money over time due to decay of option value for the person who bought your option. |
| Cons | A single loss can be huge and completely wipe off gains from many successful selling of call options. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex. |
Sell Via CFD
| Description | Establishing an agreement to sell an asset at the current price, and buying it back at a future price |
| Characteristics | Breakeven point is a short distance away, thus the probability of a trade being profitable is slightly lower than 50%. Upside and downside are balanced, unless stock price increases more than 100%. Downside is theoretically unlimited while upside is capped at 100%. Downside would breach 100% once the stock price increases more than 100%. |
| Typical win/loss pattern | Wins and losses are about equal in magnitude and frequency. |
| Preferred Market Conditions | Stable to moderately volatile environment, where stock price gains do not exceed 100%. |
| Pros | Relatively simple pricing mechanism makes it easier to accurately assess win rate and risk/reward ratios, and balance them optimally. |
| Cons | Holding CFD positions will incur financing charges, thus it may be expensive to hold them for too long. |
Conclusion
In theory, different trading conditions would be best served by different shorting techniques. In practice however, many traders do not employ all the techniques. They usually stick with either options or CFDs. For beginners in shorting, I would recommend to try out both and find the one which fits your style better.
Good luck!
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