Short trading enables investors to profit from potential falls in an asset price, though without even having to buy the given asset in the first place.
Short selling, as it is also known, used to be the preserve of institutional investors or the wealthy. These days, however, it is readily accessible to investors in general.
The advent of trading through Contracts for Difference (CFDs) means short trading is now as easy as clicking the sell button using the mouse on your laptop when you want to open a short position. To close the position, you simply click the buy button.
Handy apps such as the one offered by Capital.com mean you can even short sell via your smartphone. You can go long (buy) or go short (sell) just as easily and you change your mind from long to short or short to long from one day to the next, or even on the same day.
Understanding short selling
Imagine borrowing John´s car, selling it to your neighbour Clive for £5,400, and then buying an identical car from a second-hand car dealership for £5,000, which you then return to John. You sold an asset that you didn´t actually own.
But the interesting part is that you made £400 profit in doing so.
This example sounds a little improbable but illustrates the concept of short selling. Substituting the car for shares in a company´s stock, and adding a couple of financial counterparties into the equation, then the whole scenario becomes a lot more plausible.
It would be quite difficult to source an “identical” second-hand car. There is, however, no difference between any one ordinary share in the same publicly listed company. Just as there is no perceivable difference between any given barrel of crude oil.
Individual shares in companies, or commodities such as oil and gold, can all be shorted using CFDs. Today, many investors also turn to CFDs in order to short trade the stock market as a whole, as represented by popular indices such as the FTSE 100 or S&P 500.
CFD short trading
This is all done for you; instead you just open the short trade by hitting the sell button and close it by using the buy function.
The emergence of CFDs has made such trades much simpler and efficient than they were in the past.
Risk and controversy?
Financial institutions first began using CFDs in the 1990s to hedge the risk associated with their conventional holdings in the stock market. Opening CFD positions that would profit from falls in certain company share prices, they could thereby offset the negative impact from declines in their conventional shareholdings.
Over the following years, CFDs were adopted by a broader section of investors, who spotted the potential offered by CFD trading to maximise profits from falls as well as rises in asset prices.
Since the financial crisis, there has been some controversy over short selling. Regulators across the world have attempted to ensure there is more risk control over big short-trade positions, with the activities of banks and other financial institutions coming under increased scrutiny.
A major reason for the huge rise in popularity of CFD trading among ordinary investors is that it is only necessary to come up with a small percentage of the actual trade size.
For instance, using what is referred to as margin you could only have to pay as little as 2% of the transaction value to open a CFD position in a company´s stock.
Your CFD provider funds the rest. This is called leverage and your CFD provider must be regulated or offer margin trading.
Short trading example
Suppose we open a short CFD position in ABC shares as we expect the shares to fall. ABC is trading at 1,000/1,020p. This denotes the bid/ask spread, where 1,000 pence is the sell price and 1,020 pence is the buy price. We decide to sell 1,000 CFDs at the 1,000p bid price.
In this example, the margin will be £500 (5% x (1,000 units x 1,000p sell price)).
In the money
Happily, you were right and the ABC share price moves down over the next hour and you decide to close your position when the ask price is at 970p. This means the ask price has fallen by 50 pence.
Original 1,000p bid price minus the new 970p ask price = 30 pence
Your profit is 1,000 units x 30 pence = £300.
You have made a 60% profit on the funds you invested in the space of just one hour.
Out of the money
No one gets every trade right. Suppose instead that ABC shares rise over the hour and you decide to cut your losses when the ask price has reached 1030p.
The new 1030p ask price minus the original 1,000p bid price = 30 pence
Your loss is 1000 units x 30 pence = £300.
Limiting downside risk
It´s important to bear in mind that short trading carries some risk. Clearly, as the example above demonstrates, if you open a short-trading position on a company’s shares and the price rises rather than falls, you will suffer losses.
Fortunately, it´s easy to control risk when entering into short-trading positions. You simply implement a stop loss, which will mean the position is closed as soon as the share price rises to a certain level.
The good news is that you would still retain the same profits making potential from your short-trading position as before.
As stated earlier in this article, institutions originally used CFDs mostly to hedge the risk of their conventional long shareholdings.
Through a CFD trading platform such as Capital, it´s straightforward for any investor to short-trade CFDs for pure profit-making potential or to hedge the risk of conventional, long positions.
As an example, suppose you hold £10,000 worth of ordinary shares in ABC company, which happens to be a biotech name.
ABC is due to report some clinical trials results but you’re concerned there is a high risk of a short-term sell-off if the results fail to meet market expectations. At the same time, you still have sufficient conviction in the shares to want to hold them for the long term.
Using CFDs you could short sell the equivalent amount of ABC shares on the day the company reports the results. If the shares do decline, you stand to counterbalance the adverse price movement from your conventional shareholding with a gain from your CFD position.
The great thing about CFDs is that they can be used to profit from down as well as up moves in asset prices.
Short trading CFDs on popular share indices enables investors to profit from down days for the stock market as a whole. Meanwhile, CFDs on individual shares allow investors to potentially profit from negative news flow on a given stock or exploit trading patterns by focusing on technical indicators.
CFDs on the likes of oil and gold mean investors can potentially take advantage of some the more extreme price movements that arise from time to time in the global commodities markets.
With some appropriate research and risk control, CFDs can be a highly beneficial tool for any investor.
Over the years, CFD trading has evolved to become increasingly convenient and efficient for investors in general. Using apps, such as the one offered by Capital, you can even open and close CFD positions through your smartphone.
To learn how short selling can work for your trading strategy watch our video: