How to short sell? A quick guide to short trading
Short selling is a trading strategy where a trader speculates on the decline in a security’s price and attempts to profit from the realisation of an expected decline. It’s also referred to as “going short”, “selling short” or “shorting” the market.
In this article, we will learn more about short selling. We will explore various short selling strategies, view how CFD short selling works and find out about the potential risks and benefits of this trading technique.
What is short selling?
The SEC defines several use cases for short trading:
To try to profit from an anticipated plunge in a security’s price.
To provide liquidity in response to unanticipated demand from buyers.
To hedge the risk of a long position in the same or a related asset.
How does short selling work?
How to short a stock? Financial instruments like contract for differences (CFDs) allow traders to open short positions without the need to own the underlying asset.
A CFD is a contract between a broker and a trader to exchange the difference in value of an underlying security between the beginning and the end of the contract.
Traders can open long or short CFD positions depending on their expectation of the direction of the underlying asset price.
“According to data from retail trading platform Capital.com, 74% of all retail trades executed on the platform globally in 2021 were long. This trend has altered only slightly in recent months, even as we enter what appears to be a bearish market where opportunities to derive value from rising markets are reduced — the majority of trades remain long on Capital.com. So far this quarter, 63% of all trades on Capital.com were long,” he added.
The main difference between short selling stock CFD and shorting a stock is that the trader could take a short position without owning the underlying asset.
Short trading is not limited to stocks. Traders can also short bonds, forex pairs, commodities and other assets.
CFD short trading is leveraged and allows traders to take up positions with a fraction of the value of their trades. However, leveraged trading comes with risks as it amplifies the magnitude of both profits or losses.
Short selling example
For example, if a trader expects Tesla (TSLA) shares to go down, they can open a short position by selling a Tesla CFD.
Let’s say Tesla shares are currently trading at $1,000. A trader wanting to open a short position on the company’s shares can sell 100 TSLA CFDs at $1,000.
If the price of the stock falls to $990 and the trader closes 100 TSLA CFDs at this price, then they will have made a profit of $1,000 in total, or $10 a share.
However, markets can be volatile, and the price of the stock can go against your position. For example, if the trader sold 100 CFDs on TSLA at $1,000 a share and the price rose to $1,010, they will bear a $1,000 loss.
Benefits and risks of short selling
Trading is risky and the short selling process may come with additional precautions. Here are some short selling risks you need to consider before making any trading decision:
Since the limit to how much a stock can gain has no ceiling, short selling can theoretically result in unlimited losses to a short seller. However, traders can always use risk management tools, such as stop-losses to limit the potential loss.
A short seller may have difficulty closing a short position if there are a lot of other traders trying to do the same or if the shorted stock is a thinly-traded one. Exiting short sellers can get caught in a short squeeze as they rush to buy back the underlying asset in order to close their positions. This results in a jump in prices and higher short seller losses.
Short-sellers, same as traders holding a losing buy position, also risk the liquidation of their positions if they fail to meet the minimum maintenance requirement.
Even if a trader’s rationale for shorting a stock is valid, it could take a while for the stock price to decline, exposing the short seller to risks of margin calls and overnight fees in the meantime.
Bans on short selling on specific stocks, sectors or entire markets to avoid unwarranted selling pressure could adversely affect the fate of open short positions.
Meanwhile, short selling can also offer traders much needed flexibility among other benefits:
In taking a short position you can speculate on a potential downwards price movement of an asset. It means that you have a wider choice of trading options and can try to benefit from both, bullish and bearish markets.
Short selling is considered a high-risk, high-reward trading strategy.
Short selling may be used to hedge long positions. Hedging is undertaken with the objective of protecting gains or minimising losses. Traders may take up short positions to limit losses without exiting their long stock positions.
CFD short selling offers traders the possibility of achieving higher profits using lower initial capital due to leverage. Note that leverage can also increase losses, if the market goes against you.
How to limit risks while short selling?
Traders have to acknowledge the risks of limitless losses and margin calls before exploring short selling. It is important to understand your appetite for risk and identify entry and exit points to your trade.
According to financial services company Charles Schwab, traders should enter a stop order trade to help limit losses in the event the market moves against you.
A stop order is an order to buy or sell a stock at a specified price known as the stop price.
Short sellers can use stop orders or trailing stops to protect themselves from losses. A stop order automates a buy back of shares when the stock price rises above the stop price. In a trailing stop order, the stop price will “trail” the lowest price of a stock by a percentage or a dollar amount set by the trader.
Types of short selling
There are two types of short positions: naked and covered.
Naked short is a short position when a trader shorts securities that they do not possess. The SEC banned the practice of naked shorting in 2008. However, naked shorting could take place as a result of loopholes and discrepancies in trading systems.
Covered short is a short position when a trader borrows the security usually from a broker in return for a fee and with the obligation to return the stock at settlement. Later the trader repurchases the stock, which is known as ‘covering’ the investor’s short position.
Is short selling an effective trading strategy or a risky practice?
The possibility of limitless losses, margin calls and short squeezes make short selling a risky trading strategy.
However, equipped with knowledge of risk management tools, such as stop-losses, traders could consider short selling as another potential opportunity for trading, which allows them to speculate on bearish markets.
Abusive short-selling practices such as rumour-mongering and bear raids to drive a stock lower are illegal. Properly executed short selling could potentially be a strategy for portfolio risk management.
Short selling provides liquidity to markets, and could potentially stop stocks from inflating to unjustifiably high levels through over-optimism or hype.
What are the steps of selling short?
A trader chooses an asset they believe might decrease in value. In case of CFD trading, the trader sells the asset’s CFD at the current market price in anticipation that the asset’s value will decline. The trader might want to apply a stop loss order to limit potential losses if the price goes against their position. If the price of the asset declines, the trader might close their position and take a profit. If the price goes in the opposite direction, the trader will have to close their position at a loss.
How does short selling affect stock price?
Short selling may increase the selling of a stock, leading to a fall in prices. However, if stock prices move against short sellers, a short squeeze can occur leading to a jump in stock prices as a result of short sellers exiting their positions.
How long can you short a stock?
There is no limit to how long a stock can be shorted. However, in the case of CFD short selling, overnight fees are usually applied. It makes contracts for difference more suited to short-term trading, rather than long-term investing.
Is short selling more profitable?
The risks of losses, margin calls and short squeezes make short selling a risky trading strategy. However, it could be a plausible strategy for portfolio risk management, and an option to speculate on a bearish market.
How do you tell if a stock is shorted?
You can go to the stock exchange where the company is listed. For example, Nasdaq offers short interest in Tesla (TSLA).
Markets in this article
Tesla Inc (Extended Hours)