Short-selling goes against the traditional mantra of buying low and selling high. But it can be a useful tool, helping traders to find opportunity even in falling markets. Find out what short-selling means and how it works.
What is short-selling?
Short-selling, or a short sale, is a trading strategy that traders use to take advantage of markets that are falling in price. When you short-sell, you are selling a borrowed asset in the hope that its price will go down, and you can buy it back later for a profit.
How does short-selling work?
Short-selling works by the trader borrowing the underlying asset from a trading broker and then immediately selling it at the current market price. You don’t actually own the asset, so you will probably have to pay a lender’s fee. When you close your trade, you buy the asset back at its new price and return it to your lender. If the market does fall, you can profit from the decline, but if it rises, you’ll have to buy back the shares at a higher price and accept the loss.
Traditional short-selling comes with a few limitations. For instance, because you don’t own the assets that you are going to trade, you’ll need someone to lend them to you. This means that you could encounter issues like an unborrowable stock – the term for a share that no one is willing to lend you.
Using derivative products, such as CFDs, is an alternative way to execute the trade, since these products do not require the exchange of an underlying asset.
With CFD trading, you are agreeing to exchange the difference in price of your chosen asset from when the position is opened to when it is closed. When you short-sell a CFD, you open a position to ‘sell’ the asset. For example, if Apple shares are trading at $150 a share, and you short-sell 100, you could close your position when the price reaches $145 a share and make a profit of $500 [($150 - $145) x 100].
Example of short-selling
Suppose bitcoin is currently trading at $3500, but you think the price will go down. So, you decide to open a short position on 10 bitcoin. A week later, the price reaches $3400 and you close your position. This means you have made $1000 in profit.
This is calculated by subtracting the new asset price from the opening position price, and then multiplying by the number of bitcoin traded [($3500 - $3400) x 10].
If the price rises, you will run a loss. For example, if bitcoin rises to $3550, you will lose $500.
The main benefit of short-selling is that it increases the number of trading opportunities. The two most popular reasons for short-selling are speculation and hedging.
Short-selling gives traders a whole new dimension of market movements to speculate on – as traders can make money even if the underlying asset drops in price. Hedging is another way to use short-selling. With hedging, traders can protect against losses to a long position. For example, if you’re going long on the S&P 500, a downward move could negatively impact you. Therefore, you also open a short position to lessen the impact.
But short-selling also has its disadvantages. There is higher exposure to losses if the asset’s price doesn’t behave as you expect. If an asset’s price increases, your losses could potentially be unlimited. And if this happens, a short squeeze can occur, which means short sellers all try to cover their positions at once – pushing the price of the stock up even further and amplifying losses. This makes it important to have a risk management strategy in place.
In order to get the most out of the market via short-selling, it’s important that you do extensive planning and have a solid strategy. We have put together a few tips to get you started.
- Do a complete fundamental analysis on the market before you decide to go short
- Be mindful of your position size – the larger it is, the more risk is involved. However, if the position is very small, you might not make a visible profit
- Set up trading alerts that will notify you when your market hits a certain level and then lets you decide what to do next
- Place trailing stops that will follow your position if it earns a profit and close if it reverses
- Place guaranteed stops to close your position once it rises to a certain point. This puts a limit to your downside and you’ll only have to pay a small charge if your stop is triggered
Short-selling summed up
We have summarised a few key points to remember on short-selling below.
- You can go short on a market of your choice, via CFD trading or by borrowing stock from a broker
- If the underlying market price dips, you could make a profit
- It’s important to have the appropriate risk management tools in place to avoid big losses
In a nutshell, you can use short-selling to speculate on falling market prices – giving you the opportunity to profit from bear markets as well as bull runs.
Anzél Killian | Financial writer, Johannesburg