CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 87.41% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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How to short sell? A quick guide to short trading

By Mensholong Lepcha

Edited by Alexandra Pankratyeva

09:33, 26 May 2022

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TSLA
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182.66 USD
2.12 +1.170%

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How to short sell? A quick guide to short trading мужчина стоит в пиджаке и надпись на фоне
How to short sell? A quick guide to short trading Photo: Brasil Creativo / Shutterstock.com

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 US Securities and Exchange Commission (SEC) defines short-selling as follows:

“A short sale generally involves the sale of a stock you do not own (or that you will borrow for delivery). Short sellers believe the price of the stock will fall, or are seeking to hedge against potential price volatility in securities that they own. If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss.”

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. 

“It’s widely known that retail traders and investors are usually buying in anticipation of a price rising — and then sell to close the position to realise a profit or loss. They are very rarely short-sellers: using a sell to open a position to try and profit from a fall in price,” said David Jones, Chief Market Strategist at Capital.com. “As a general rule, DIY traders and investors seldom short-sell. They are so used to buying first and selling later that it's psychologically very difficult for them to come out of this way of thinking — it's ingrained in people.” 

“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.

Short selling example: Tesla (TSLA)

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.

Natural Gas

6.89 Price
-5.230% 1D Chg, %
Long position overnight fee 0.0486%
Short position overnight fee -0.0751%
Overnight fee time 22:00 (UTC)
Spread 0.005

Oil - Crude

80.70 Price
+2.240% 1D Chg, %
Long position overnight fee -0.0095%
Short position overnight fee -0.0042%
Overnight fee time 22:00 (UTC)
Spread 0.03

XRP/USD

0.40 Price
+0.480% 1D Chg, %
Long position overnight fee -0.0500%
Short position overnight fee 0.0140%
Overnight fee time 22:00 (UTC)
Spread 0.00330

BTC/USD

16,899.60 Price
+2.530% 1D Chg, %
Long position overnight fee -0.0500%
Short position overnight fee 0.0140%
Overnight fee time 22:00 (UTC)
Spread 66.00

Short selling example: Tesla (TSLA)

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. 

According to the Financial Conduct Authority (FCA): “High-risk investments may offer the chance of higher returns than other investments might produce, but they put your money at higher risk. This means that if things go well, high-risk investments can produce high returns. But if things go badly, you could lose all of the money you invested.”
  • 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. 

FAQs

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).

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The difference between trading assets and CFDs
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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