Short selling, or shorting, is a way of making money when an asset’s price falls.
- Short selling is the process of speculating that a financial instrument – like a stock or cryptocurrency – will fall in value.
- Short selling allows you to balance your portfolio and profit when the market is down.
- The two most popular methods of short selling are margin trading and derivatives trading.
What is short selling?
It is the practice of investing capital in the belief that something will fall in price. So, in the case of a stock, it is the act of borrowing shares from a broker with the aim of selling them back later at a lower price. If you succeed, you get to make a profit on the difference.
When you buy the shares back to repay your broker, this is known as ‘covering’ your position. Until you cover, you still owe the broker its shares. If the market goes the other way, large increases in price can make shorting expensive.
For example, if you borrow a stock and sell it for £100, then cover your position (buy it back) for £90, you can return the stock to the broker and pocket the £10 difference. However, if the stock’s price rises to £110, you will lose £10.
How to succeed at short selling
Shorting is generally best as a short-term strategy. Over time, stocks tend to go up, which can make holding on for too long a risky strategy. Moreover, if a stock issues dividends, you can lose out every quarter when the dividends are paid out.
It’s always a good idea to thoroughly research the company you want to sell short, along with its main competitors and the state of its industry. Be sure to carry out consistent research so know why you’re selling short and be ready to react to new developments.
What to consider when short selling
Short selling stock is a way of benefiting from falling prices, something that you would otherwise be unable to do. When there is a big market drop, rather than waiting for assets to bounce back, which could take a long time, you can bet on assets or entire industries to fall. Furthermore, you can use leverage, which allows you to increase the size of your investment via borrowing.
Having several short positions can help balance a portfolio that is heavily weighted with long positions (investments on the basis that an asset will rise in value). This helps protect (hedge) your portfolio against adverse market conditions.
As well as its usefulness for investors, shorting also has a key role to play in overall market dynamics. If stocks weren’t shorted, liquidity would be limited, and assets would not be able to trade freely or experience regular price fluctuations.
The biggest disadvantage of short selling is that there is no limit to how much a stock can rise. When you buy a stock, the worst possible outcome is the price falling to $0. When you’re short, the price can rise to a value that might be many times the size of your original investment.
Brokers can also play a role in short selling. As you usually have to borrow shares to be able to go short, they need to be sure you can afford to pay them back if the price rises. Often, you have to maintain a certain percentage of the cost in your account to be able to keep selling short.
The different methods of short selling
Short selling is usually done in one of two ways. One method involves using a margin account, and the other is trading with derivatives – specifically CFDs and spread betting.
For example, with a margin account, a trader will first identify a stock that they believe will fall in value. Then, they borrow this stock from a broker, sell it into the market and wait for its price to fall. Once this occurs, they repurchase the stock, return it to the broker and pocket the difference. For every day the trader borrows the stock, they must pay a loan fee to the broker.
CFDs and spread betting have some key differences but are largely similar. When using these two instruments, you are not borrowing a stock to short it outright. Instead, you are creating a contract that represents a bet that the price of an asset will fall.
Should I use a margin account or derivatives?
For those who want to hold a more long-term short position, margin accounts can be beneficial because they allow you to continue earning dividends on borrowed stocks.
By contrast, while dividends are not earnable on derivatives, they come without loan fees and provide the flexibility that short-term traders who are making regular trades need.
Where can I learn more?
To learn more about short selling, we recommend checking out our detailed how-to guide. Otherwise, to learn more about the financial markets in general, be sure to check out our stock, cryptocurrency, or commodities hubs.
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