What is short selling and how do you short a stock?
City Index January 29, 2021 11:11 PM
Short selling is a popular trading and investment method used to take advantage of falling market prices. It can be extremely lucrative if you get it right, but it does come with big risks. Discover what shorting a stock is and how to take your first short position.
What is short selling?
Short selling is the common practice of opening a position in the expectation that a market is going to decline in value. Shorting is often associated with stocks, but you can short sell a range of assets – including forex, indices, commodities and interest rates.
In traditional investing, you’d take a long position, believing that the market is going to rise in price. Later, you’d close your position by selling the asset on and taking any profit. When you short sell, you’re taking the position that the market is going to fall in value. Later, you’d close your position by buying the asset back for a lower value and taking the difference as profit.
It is most commonly used as a means of speculating on market prices, enabling you to take advantage of bear markets and short-term declines. Short selling can also be used to hedge against the downside risk to a position you currently have.
What does shorting a stock mean?
Shorting a stock is the process of borrowing shares that you don’t own and selling them to another investor. The aim is to buy the shares back later and return them to your lender, pocketing the price difference.
You would short a stock if you have a bearish position on the future of the company – either in the short term or over a longer timeframe.
How does short selling a stock work?
Short selling works by borrowing shares – usually from a broker or pension fund – and selling them immediately at the current market price. Later, you’d close your position once the market has fallen, buying the stock back and returning it to your broker for the new, lower market value. The difference between the initial price you sold the shares for and the price you bought them back to is your profit.
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For example, let’s say you thought shares of Company XYZ were going to fall from their current price of £50 per share. You contact your broker and borrow 10 XYZ shares and sell them immediately for £500.
Your prediction was correct and XYZ stock did fall in value, down to £30 per share. So, you close your position by buying back the shares at the new price of £300. You’d return the 10 shares of XYZ to your broker and pocket the £200 difference yourself.
Finding a broker willing to lend you stocks to short can be difficult, as they’re essentially taking on the risk that you’ll be correct and return their shares at a much lower value. This is why most brokers will charge you interest for as long as your position is open.
Short selling via a broker is often referred to as the traditional way to short a stock but thanks to the rise in derivatives trading, it’s no longer the most common.
When you short sell with derivatives – such as CFDs and spread bets – you won’t need to borrow the shares before you take your position, as you’re just speculating on the underlying market price. You’d just need an account with a derivatives provider, and you could open a short position simply by selecting ‘sell’ in the platform.
As shorting via derivatives is a much simpler process, it’s become a popular choice for traders looking to take advantage of downward markets.
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How to short sell a stock
- Choose a stock to sell using analysis
- Open a position to ‘sell’ the stock – either via your broker or with a derivative
- Monitor the market
- Buy the shares back at the new market price
If your initial prediction was correct and the stock fell in value, you could close your position and profit from the difference between your sell and buy prices. But, if the market had increased instead, you’d have to buy back the shares at a higher price and pay the difference – ultimately generating a loss.
The risks of short selling
Short selling is riskier than traditional long positions, as there’s theoretically an unlimited upside for a market, so if your prediction is wrong you could incur infinite losses. This makes risk management a crucial part of preparing for a short position. With us, you can attach a guaranteed stop to your position to make sure your position closes automatically at a level of loss you’re comfortable with.
Another risk is that a short squeeze occurs, this happens when the market rallies and short-sellers need to exit their positions quickly. Squeezes are a chain reaction, so as more shorters close their positions, the price is driven higher, causing even more traders to sell.
Learn more about what short squeezes are.
Example of a short squeeze: hedge funds vs GameStop
Hedge funds are the most notorious short-sellers, as they frequently use short positions to hedge their long positions on other stocks. But it’s always worth noting that even such active shorters aren’t immune to the risks of short selling.
For example, in January 2021, institutional investors – including the hedge fund Melvin Capital – saw an opportunity to go short on GameStop’s falling price. The gaming firm had experienced a few years of declining revenues and forced store closures, which made short selling the stock seem like a sure thing.
However, huge numbers of amateur investors decided to buy GameStop shares – or rather stock options – to send a message to Wall Street short-sellers that profiting from the company’s troubles was wrong. Several Reddit users asked people to push the price up and create a short squeeze. The sheer volume of buyers caused a huge rise in GameStop’s share price and massive losses for the hedge funds involved.
The hedge funds and investors that were short on the company were forced to find buyers to stop their losses from rising any further. This created additional demand and pushed the price up even further.
Short selling summed up
- Short selling enables you to take a position that an asset is going to fall in value
- The practice of shorting is often used for stock trading but can be used for other assets such as currencies, commodities and indices
- Traditional stock short selling involves borrowing the asset from a broker, selling it on the market, and buying it back at a lower value – profiting from the difference in price
- Short selling with derivatives, such as CFDs and spread bets, means you don’t have to borrow the shares. You’ll have the option to short sell any market by clicking ‘sell’ on the platform
- Short selling does have risks, such as infinite losses and short squeezes
- It’s important to manage your short-selling risk with stop-loss orders
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