What is Short Selling (Shorting) and How Does It Work Exactly?

You might have heard the term ‘shorting’ a stock, referring to traders and speculators being able to create market opportunities when the price of an asset falls. There might be time when you wish you could personally bet against an asset and potentially benefit from its downturn.

If you’ve searched the web and read articles but are still confused about how does shorting work and where the opportunities from a short position may come from, then read on as we demystify this trading technique – once and for all.

What is Short Selling?

Let’s begin by explaining the desired result of a short, and then explore how this desired outcome can be achieved.

In a conventional (also known as ‘long’) trade, you buy lots of a stock in the stock market and sell these lots in the future when the stock price goes up. On the flipside, a ‘short’ position allows you to trade in the opposite direction; particularly when you speculate that the stock’s price will goes down. 

How this works is that the short-seller who wishes to enter a short position ‘borrows’ lots of the particular stock in which the trader believes will decrease in price and promises to return them in the future – with a slight premium for their trouble, also known as the borrow-rate. 

Upon ‘borrowing’ the assets, the trader sells them at the present market price in hopes of being able to purchase them at a lower price in the coming minutes, hours or even days. If the stock price falls as speculated, it becomes much cheaper for the trader to repurchase and return them to the original owner. 

The trader can thus potentially create short-selling opportunities from the stock price movements. This is what is implied when a trader mentions that they ‘short a stock’.

It is also important for traders to note that for futures, or contracts-for-difference (CFDs), short positions can be entered into without having to actually borrow assets from other investors. This is due to the nature of the product, where traders enter a contract with the broker by speculating on the rise or fall in price, without having to own the actual product. Read more about CFDs vs stocks here.

Sign up for a live account with Vantage today and get started with CFD trading. Explore our library of comprehensive articles and learn how to leverage market opportunities in both rising and falling markets.

An Example of How Short Selling Works Using CFDs

Imagine we have a stock that is trading at $10. As a Contracts-For-Difference (CFD) trader, assuming that you believe that the price of this stock will fall, you decide to enter into 1,000 SELL contracts at the current price.

A week later, the price of the stock falls to $9. You decide to close your trade by executing 1,000 BUY contracts. As a result, you have made a profit of $1,000 ($1 x 1,000 contracts). In this example, transaction costs, borrow-rate costs, and other fees have been omitted.

Traders can also use a margin account to enter into a short sell using CFDs. However, it’s crucial to note that short selling through margin trading can be highly risky. If the stock price were to unexpectedly rise instead of fall, you might encounter a margin call, requiring you to deposit additional funds to cover potential losses from your initial investment and maintain the position. Failing to meet a margin call could lead to the forced closure of your position at a loss.

For more insights on the difference between margin and free margin, delve deeper into the topic by clicking here.

Why Do Traders Short Sell?

There are two main advantages of short selling stocks.

1. Capitalise on downward price movements 

The first is to take advantage from a bearish market or from anticipated falls in prices. Shorting gives traders yet another instrument they can use to implement a myriad of trading strategies and create opportunities from all market conditions.

Read more about bear market at our Academy to gain a better understanding of the market condition.

2. Hedging

The second main use of shorts is as a form of hedge. If a trader observes that their current open positions have departed from their desired risk parameters, entering into new short positions allow them to still maintain their positions safely without having to liquidate.

As with all other trading instruments, shorting simply gives traders additional options for them to find and hone their edge in the financial markets.

Risks of Short Selling

In a conventional ‘long’ trade, your downside is finite, since the most you can lose is the price at which you bought the stock; or should the worst happen and its value falls to zero. However, your potential upside is infinite since there is theoretically no limit to how high the price of the stock can go.

A short trade, on the other hand, has finite upside and potentially infinite downside. This is because in the best-case scenario, the price of the stock falls to zero, and that is the most a short seller can make from that trade. However, since there is no limit on how high the price of the stock can climb, the risk of loss on a short position is theoretically unlimited. In other words, you may lose significantly more in a short position than a conventional long position.

Thus, when placing short trades, putting a stop-loss is of key importance in order to properly manage the risks of losing your entire invested capital and more.

In Short Selling, Timing is Everything

It is crucial in short selling trades that you aim to get the timing right. This is because, even if you are right about the general price direction of an asset, you could still get wiped out from intermittent swings in prices, which could trigger stop-losses or margin calls.

As with all trades, but perhaps even more so for short selling, traders should trade responsibly starting with familiarising themselves with their trading tools and implementing robust risk management protocols in their trading strategy. 

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