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. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  8. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  9. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  10. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  1. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. 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 >>
  5. 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 >>
  6. 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 >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center