The risks involved in short selling can never be overemphasized, which is why novice investors are cautioned against doing it. However, the advanced trader would be limiting him or herself by not exploring the various opportunities short selling can offer. Some investors, for example, will often protect themselves from downturns in the market with an offsetting short position, thereby protecting their long positions. Regardless of your purposes, it is always important to use indicators that help you discern shorting opportunities, and here we look at how the VIX can give you greater insight into market directions.

Defining Short Selling
When investors buy stocks for their portfolios, the term we use for acquiring an issue is 'going long.' If, however, the investor believes a stock is about to turn downward for a period of time, the investor may sell the stock (without first buying it), or 'go short.' An investor borrows the stock from his or her brokerage, sells the stock, and later buys it back again (or covers the position) at a lower price, effectively making a profit in a downtrend.

The borrowing process is relatively simple. The investor's broker is asked to borrow the stock from another investor, and the short seller must provide cash collateral of about 50% of the price of the short sale. Also, the short seller is responsible for any dividend that may be paid while his or her position is still open. Remember, the short seller has only borrowed the stock - someone else holds the rights that come with ownership.

The Dangers and the Short Squeeze
It is important to stress the perils of short selling an issue. Consider for a moment the potential losses. You know that if you go long on an issue, the most you can lose if the market heads south is the total amount of money invested, which is a finite number. A short seller, on the other hand, can have losses of the unlimited variety. Say you short sell stock ABC when it's at $10, and the issue turns upward - where does it end? Theoretically, it could keep going forever.

Every short seller should also be aware of the short squeeze, which occurs if the brokerage firm recalls the stock that you have borrowed and you have a difficult time buying back into the market because of the lack of market liquidity. A short squeeze finds traders with an increased demand for an issue that is in short supply, and the stock price is therefore driven higher. Investment and hedge fund managers watching support levels will rush into a stock they believe is ripe for the picking at cheaper prices. Because of the size of blocks of stock with which these large funds come to the market, the stock price can move upward very quickly and without warning, squeezing short sellers and forcing them to buy back in and cover their positions, which in turn pushes the stock price even higher!

Short sellers need to understand support levels, and be prepared to buy back into the market just above the support zone. Why just above the support zone? Well, everyone else is looking at the same support levels on the same charts you are, so by placing yourself just above the support zone, you have a better chance of covering your outstanding position before the herd.

The Chicago Board Options Exchange (CBOE) volatility index, or VIX, measures market volatility. Essentially the VIX forms a hypothetical at-the-money option that will expire in 30 days. When originally designed in 1993, it was calculated using a weighted average of the implied volatilities of eight S&P 100 index options (OEX) with an average expiration date 30 days into the future.

In September 2003, the CBOE made some amendments to the VIX, basing it on prices of the S&P 500 (SPX) options and devising a new formula to take into account a much wider range of strike prices. Also, the at-the-money strikes now have the most weight. But the basic concept remains the same, and the new VIX plays out much the same as its predecessor.

In its uses, the VIX gauges investors' confidence in the market conditions and is a good measurement of whether OEX options are overvalued or undervalued. If the VIX reading is low, below 20 to 25%, the sentiment is one of disinterest: investors are quite content with the direction the market is taking in general. A rising VIX has investors coming back into the marketplace with what could be a market turnaround. If stock valuations are falling off and the VIX is rising, investors who have shorted a stock should worry that the increased interest in that issue could sharply turn the stock upward with gusto over a short period of time.

Using the VIX in Short Selling
Here is an interesting situation that may show how a short seller can use the VIX in his or her strategy. When looking at the huge jump in convertible bonds issued in 2003 (Thomson Financial indicated an increase of convertibles from $60 billion to $96 billion year over year), some analysts concluded that, with the enormous amount of call options available, the supply would rise, the prices would fall and the VIX would fall off.

Let me connect the dots for you. A convertible bond gives an investor the option to convert to the stock on the same company at a set price - it's not unlike a call option. With interest rates at a generational low and investors looking for a strong yield return, it is no wonder the numbers jumped to $96 billion.

In the first chart you can see the trading activity of the Dow Jones Industrial Average (DJIA) in the last months of 2003. Plain to see is the lack of interest shown by investors in the VIX Index as the DJIA shows a continuing upward trend. Again, this doesn't mean that investors do not have interest - even though it indicates they are content with the direction it is currently taking, which is a steady upward trend. The VIX is falling off under the table, well below the 25% mark.


In the second chart, I have run some support lines that investors as well as institutional traders would watch if the market were to turn around sharply and head lower. The first area of support is established on October 24 at about 9500 (#1 in the first chart), and the second area that would be watched is developed around September 30 - October 1, when the Dow dances around the 9275-9300 levels (#2 in the first chart). And thirdly, on August 6, the Dow closes at 8993,(#3), so the seasoned market players would be watching the 9000 level closely as a level of support, both numerically as well as psychologically.

It is important to note that market veterans would use much smaller time frames to see a turnaround in sentiment sooner. Next time you are looking at your charts, change your time frame from daily bar charts to 30-minute views or less. A market can move very quickly and sometimes it happens in a matter of a few short hours.

Take a serious look at the support levels before jumping into the short selling forum, and bring the VIX along for greater insight into the directions the markets are taking. Above all, stay on top of any short selling. The markets can turn on a dime. Don't get 'squeezed' out of the game.

For related reading, see Volatility - The Birth Of A New Asset Class.

Related Articles
  1. Options & Futures

    Volatility's Impact On Market Returns

    Find out how to adjust your portfolio when the market fluctuates to increase your potential return.
  2. Mutual Funds & ETFs

    The VIX: Using The "Uncertainty Index" For Profit And Hedging

    Learn the best ways to profit and hedge using the Chicago Board Options Exchange Market Volatility Index.
  3. Options & Futures

    Hedge Funds: Higher Returns Or Just High Fees?

    Discover the advantages and pitfalls of hedge funds and the questions to ask when choosing one.
  4. Options & Futures

    Hedge Funds Hunt For Upside, Regardless Of The Market

    Hedge funds seek positive absolute returns, and engage in aggressive strategies to make this happen.
  5. Active Trading Fundamentals

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  6. Options & Futures

    Volatility Index Uncovers Market Bottoms

    VIX can gauge when the market has hit bottom - a welcome sign of better things to come.
  7. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  8. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  9. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  10. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...
  1. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  3. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  4. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  5. What are the alert zones in a Fibonacci retracement?

    The most commonly used Fibonacci retracement alert levels are at 38.2% and 61.8%. A 50% retracement level is also commonly ... Read Full Answer >>
  6. How was the Fibonacci retracement developed for use in finance?

    The use of Fibonacci retracements in stock trading was popularized by noted technical analysts W.D. Gann and R.N. Elliott. ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!