Introduction to short selling

In the past, investors could only profit from markets where prices were rising, but today, you can profit from price declines as well.

1. What is short selling?

2. Short selling of stocks

3. Short selling with derivatives

4. Hedging with short positions

5. Risks of short selling

What is short selling?

Short selling is a trading strategy that allows you to profit when the price of an asset declines. Typically, trading is associated with "buying low and selling high." While this is an effective way to make a profit, it is not the only option. "Selling high and buying low" is equally effective.

To open a short position, you trade at the bid price instead of the ask price. When you decide to close the position, you buy back at the ask price, which is the exact opposite of how traditional trading works.

Short selling is not limited to currency pairs, as we showed in the "Forex Trading" lesson. You can also short stocks and many other markets. Let's see how short selling works with stocks.

Short selling stocks

When short selling stocks with a broker, you sell the stocks to open your position. Since you don't physically own these shares, your broker lends them to you and sells them on your behalf. The proceeds from the sale are then credited to your trading account.

When you decide to close your trade, the broker uses the cash in your account to purchase shares at the current price. If the shares are cheaper than when you sold them, the difference between the selling and buying price is your profit.

Example of Short Selling ABC Corp. Stocks:

Imagine ABC Corp. shares are trading at $100 per share. You expect the price to decline, so you decide to short 100 shares. Your broker lends you the shares and sells them at the current price of $100 per share, giving you $10,000.
A few days later, the price of ABC Corp. shares drops to $90 per share. You decide to close your position and buy back 100 shares at $90 per share, costing you $9,000. The difference between the price you sold the shares at ($10,000) and the price you bought them back at ($9,000) is your profit of $1,000.

However, it is important to note that short selling is a risky strategy. If the price of the shares increases instead of decreasing, you could incur a loss. For example, if the price of ABC Corp. shares rises to $110 per share, you would have to buy them back at this higher price, resulting in a loss of $1,000.

Thus, when short selling, it is crucial to thoroughly analyze the market and set clear rules for risk management.

Short selling with derivatives

Sometimes, it can be difficult to find a broker that allows individual traders to short sell stocks. However, with derivatives like CFDs (Contract for Difference), you can trade on a price decline without actually owning the asset. With CFDs, you can go long or short without the need to borrow shares.

Furthermore, short selling with CFDs is not limited to stocks. You can short any market where CFDs are available, such as forex, commodities, stock indices, and more.

Opening a short position with CFDs is the opposite of opening a long position. You decide how many CFDs you want to sell and trade at the bid price. Then, when you want to close the trade, you buy the same number of CFDs at the ask price.

Hedging with short positions

One of the main reasons traders opt for short selling is to use it as a hedging tool. Hedging is essentially a way to protect yourself against negative market movements. When you choose to short as a form of hedging, you open a position that can make a profit if your original long position incurs a loss.

Imagine you own Dow Jones stocks in your investment portfolio but are concerned that the market might decline, such as during a potential bear phase. In this case, you could short (sell) five CFD contracts on Wall Street. If U.S. stocks do indeed fall, your losses from the stocks may be partially offset by the gains from the CFD positions you opened.

Risks of short selling

When purchasing most financial instruments, you know exactly what your maximum potential loss could be. For example, if you invest $5,000 in gold, the biggest risk is that gold could become worthless overnight, and you would lose your $5,000 investment.

However, with short selling, there is no limit to how much the price of an asset can rise. If you decide to short sell stocks and their price rises, you could lose your entire invested capital.

Imagine you short sell stocks of a company that is in trouble, and the price is $50 per share. The best-case scenario is that the price of the stocks falls to zero. On the other hand, if news breaks that another company is interested in buying it, the stock price could rise significantly above $100 per share in a single day.

Example of short selling risks

Using risk management tools like stop-loss orders and limits is crucial when you decide to take a short position. These tools help protect against uncontrolled losses. We will discuss these tools in more detail later in the course.

Short selling can also bring additional costs associated with borrowing the assets from the broker to open the trade, which can affect the overall profitability of the trade.