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