Last Updated on 3 April, 2021 by Samuelsson
Swing trading has become a popular style of trading for active stock traders. Because of the requirements for short selling, most people assume that they can only go long when swing trading. So, the question is, can you go short when swing trading?
Yes, you can go short when swing trading if you meet the necessary requirements to make that kind of trades. To be able to short sell stocks, you need to have a margins trading account so that you can borrow stocks from your broker. While the Financial Industry Regulatory Authority (FINRA) has a basic requirement for opening a margins account, different brokers may have their own in-house policies.
In this article, you would learn the following
- What swing trading is
- What short selling and how it works
- Why you can go short when swing trading
- How to identify stocks to short when swing trading
- Strategies for going short when swing trading
- Risks of shorting a stock
- Some short selling tips
What is swing trading?
Swing trading is a trading style that focuses on benefiting from medium-term price movements. The trading style can be employed in trading stock, forex, futures, and commodities, but here, we will focus on stocks. Swing trading aims to capture the individual price swings on the daily timeframe. With the average trade duration lasting from a few days to a few weeks, swing trading lies in the middle of the spectrum between day trading and long-term investing.
While they may respect the overall trend direction, swing traders don’t attempt to ride the full trend; instead, they try to try to capture each swing as it comes. They may trade only the impulse swings and wait out the pullbacks, but in a range-bound market, they may trade both the upswings and the downswings.
Swing traders mostly use technical indicators to determine the stocks to trade and the best time to buy or sell them. To exploit the opportunities, swing traders act quickly to increase their chances of making a profit in the short-term. Unlike in day trading where trades are closed by the end of the trading day, swing trades last through the nights and are exposed to overnight and weekend price gaps.
How swing trading works
Swing trading involves taking a position in a stock for a couple of days to several weeks to profit from anticipated price movement. Because it is a medium-term trade, swing traders lean more on technical analysis than fundamentals to select stocks, though the latter can be used to enhance stock screening and analysis.
The idea is to identify momentum stocks with lots of movement and enough liquidity. These stocks are put in a watch list where the trader monitors them from time to time to know when a trade setup forms based on his predetermined criteria for spotting a trade setup. Swing traders often look for opportunities on the daily charts but may step down to the 4-hourly chart to find precise entry points.
On identifying a trading opportunity, the trader places a trade, sets his stop loss and profit targets, and waits for the trades to play out.
What is short-selling?
Short selling simply means selling borrowed stocks with the intention of buying them back lower in the future and profiting from the price decline. The trader borrows a stock from a broker and sells the stock, and then when its price has dropped, he buys the stock back and returns it to the broker. Short selling epitomizes the trading adage, “sell high and buy low.”
How short selling works
Most people find short selling somewhat confusing because they don’t know that they can borrow stocks from brokers and sell. However, there is a system in place for borrowing stocks. Traders can borrow securities from a broker, only after they have opened a margin account.
A margin account is a stock trading account that qualifies the holder to borrow money or securities from the broker after making a good-faith deposit, known as the initial margin. An initial margin is an initial amount a trader must deposit with a broker to be able to access margin loans from them. It acts as collateral against some or all of the credit risk the holder poses to the broker.
The requirements for opening a margin account vary among brokers, but the usual standard is the $2000 minimum deposit in cash or securities required by the Financial Industry Regulatory Authority. Most brokers require more than the $2,000 minimum initial margin. This collateral can be in cash or securities like stocks, bonds, mutual funds, or any other publicly traded securities that trade at least $5 per share. Margin loans often come with a periodic interest, but the rate is usually low.
FINRA’s rule specifies that a trader cannot borrow more than the amount he deposits as an initial margin. That is, the minimum a trader can deposit is 50% of the total worth of the position the trader wants to take. However, most brokers don’t lend up the amount deposited. Most brokers can only lend you half of the amount deposited, which means, you need to deposit at least 66.7% of the position size you intend to take.
For example, let’s say you want to short $10,000 worth of Apple stock, and your broker has a 66.7% initial margin requirement. This means that you would have to provide 66.7% of the money needed to acquire $10,000 worth of Apple stock, which is $6,700 in this case. The remaining $3,300 would be lent to you by your broker.
When short selling, if a swing trader shorts securities with margin funds and the price drops by more than the interest rate charged on the margin loan, the trader will not only be in profit but also making money from the loan.
The idea of short selling is to profit from the decline in the share price. For example, you just sold 1000 shares of APPL at the current market price of $120 per share. Assuming your forecast turns out to be right and two weeks later, the price slides down to $90 a share. To cover your short position, you buy 1000 shares of APPL at $90. So, you have made a profit of $30 per share, which, for the 1,000 shares, is a $30,000 profit (before interest charges on margin loans). The trade was profitable because your buy price was lower than your sell price.
Why you can go short when swing trading
Short selling, by nature, is a form of swing trading because the trader only holds such a position for a short time until the price reverses to the upside. However, when swing trading, short selling can be used for speculating and hedging. As a speculative strategy, swing traders can use short selling to bet and profit from a potential decline in a specific stock or across the market as a whole. As a hedge, swing traders can use short selling to protect gains or mitigate losses from market movements.
Since swing traders are primarily momentum chasers, short selling allows them to profit from every market trend. When markets are bullish, swing traders profit from going long. In the same vein, when markets decline swing traders can profit by selling short. Since swing traders do not retain positions in stocks for a long time, and as such, may not have to wait out a bearish trend as long-term traders do, they have the opportunities to profit from the decline in stock prices. Hence, short selling offers another opportunity for swing traders to make money.
How to identify stocks to short when swing trading
These are some ways, based on technical analysis methods, you can screen and identify stocks that qualify for short trading:
The stock is weak and in a weak sector too
Swing traders can use industry or sectoral based performance to identify stocks to short. This type of stock may be part of a declining industry. For example, at the height of the pandemic when people were made to stay at home due to the restrictions placed by the government to curb the spread of the virus, energy stocks took a plunge due to the drop in global oil prices as fewer people were commuting or traveling.
Shorting weak stocks in the energy sector at that time would have been a profitable a very profitable approach. However, following the discovery of the vaccine, shorting energy stocks would be ill-timed because more people would be able to travel after being vaccinated. Swing traders can always look at industry performance to determine which stocks to short.
The stock trades below its 200-day moving average
Generally, stocks that are trading above the 200-day moving average are believed to be strong, while those that are trading below the 200-day moving average are believed to be weak. So, choosing stocks that are trading below the 200-day moving average enhances your chances of shorting a stock that is on a decline. It is even better if the 200-day moving average line is also declining; it further shows that the stock is weak.
The stock has a significant run-up or price gap
What goes up must surely come down is a popular adage in stock trading, but you have to be careful not to trade against the momentum. So, look for stocks that experience an unusual run-up in a short time or has a price gap. If a stock has experienced a significant run or price gap, then there is every chance that it would decline. At a point, traders may want to take profits and trim their positions. In the case of price gaps, the price would have to decline to fill the gap, before it trends upwards again. Swing traders can profit by shorting such stocks. However, they should base their trading decisions by using technical indicators such as the RSI and MACD to identify when such stocks begin to decline.
The stock breaks through support
Support is an area where the price of a stock struggles to break below. Simply put, it is the level where the price of an asset tends to stop falling due to a concentration of demand or buying interest: As the price of the stock drops, its demand increases, thus forming the support. So, when a stock breaks through support, it is an indication that the rice would fall further. For example, assuming that the support level for around APPL $120, if it declines below $120, it would be expected to fall further until it establishes new support, say $90. Swing traders can capitalize on support breakdowns and profit from the price decline.
Strategies for going short when swing trading
There are several strategies that a swing trader can employ to identify short-selling opportunities and trade setups. These are some of them:
- Mean-reversion strategy on weak stocks: The mean-reversion strategy is commonly used in swing trading and can work in identifying short-selling opportunities in weak stocks. The strategy is based on the fact that the price tends to make exaggerated moves to either side of the mean price and then tries to revert to the mean. While trying to go back to the mean, the price overshoots again and tries to revert to the mean again. This up and down movement creates tradable opportunities that traders can exploit using some indicators and tools. For short selling, the key is to identify when the price is in an overbought situation and is likely to start declining so that you can ride it down to the mean. Some of the indicators you can use to identify the overbought conditions include the Bollinger Bands, RSI, moving averages, and price action setups at strong resistance levels. You can only use this strategy for weak stocks that are trading below their 200-day moving average.
- The breakdown strategy: A breakout strategy aims to enter a short position when the price breaks below a known support level. This strategy is best suited for a stock in a bearish trend. When the price breaks below the support level, it shows that there is a huge selling potential in the market, so the price might keep dropping. An example of this strategy is when the price closes below a 20-day low after a poor earning result. It is a good situation to short the stock.
- The momentum strategy in a bear market: The momentum strategy is also known as the trend-following strategy, which can be used in a bear market when the momentum is bearish. Here, you aim to short the stock after a temporary price rally in a bearish trend. The idea is to trade the downward impulse wave and hop out when a new rally (pullback) starts. It is preferable to short around a resistance level after a weak rally.
Risks of shorting a stock
Short selling as a part of swing trading comes with risks, which you must know and plan for. Historically, the stock market tends to have an upward bias. We are currently in the longest-running bull market which implies that stocks have been rising. Short selling in such market conditions can be unprofitable if proper analysis is not done. There is a risk that the stock will move higher after you have sold, leading to a short squeeze and forcing you to cover your short at a higher price. So, you end up losing.
Another important factor to note is that short selling is usually done on a margin account, so part of the money is loaned from the broker. Swing traders may incur huge trading costs from interest on margin loans which would eat into profits. Thus, if the trade is not making enough profit to cover the interest on the loan, the trader may be taking a loss even when the trade is in his favor.
Furthermore, if a stock is not liquid enough, it can be challenging to find shares to borrow. Moreover, if the shareholder who lent the stock wants those shares back, you’ll have to cover the short. Finally, stocks with short interest are usually targeted for short squeeze by bullish investors. A short squeeze occurs when short sellers are forced to buy back the borrowed shares to reduce losses from rising share prices. This action inadvertently pushes the prices of the shares higher. Bullish investors can trigger short squeezes by buying the stocks thus making their price rise. This would force short sellers to cover their positions.
Tips for going short when swing trading
Here are some tips that may help you when you want to try out short selling:
- Look for stocks that are selling off
- Don’t short a stock based on valuation.
- Avoid stocks that are showing bullish momentum.
- Avoid stocks that are rising above their 200-day moving average
- Never go short on a thinly traded stock; it sets you up for an easy short squeeze.
- When going short on a stock, make sure you place a protective stop.
Yes, you can go short when swing trading if you have a margins trading account that qualifies you to borrow stocks from your broker. However, the hard part is in knowing the right stocks to short sell and when to successfully make the trade. You can learn this by enrolling in a good swing trading course. However, if you don’t have the time and patience to learn, you can subscribe to a trading signal that tells you the stock to short and when to place a trade.
Here you can find our archive with all our swing trading articles.