How to short sell – a guide to short trading

Short selling carries risks, including losses and short squeezes. Can it still be effective?

Short selling is a trading strategy where a trader speculates that a security’s price will decline and aims to profit from that expected fall. It’s also known as ‘going short’, ‘selling short’ or ‘shorting’ the market.

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.”

According to the SEC, short selling can be used to:

• Try to profit from an expected fall in a security’s price
• Provide liquidity during periods of high buying demand
• Hedge against price risk in a long position in the same or a related asset

How does short selling work?

Financial instruments such as contracts for difference (CFDs) allow traders to open short positions without owning the underlying asset.

Short selling involves speculating that an asset’s price will fall. A trader effectively ‘borrows’ the asset to sell it at the current market price, aiming to buy it back later at a lower price and return it – profiting from the difference if the market moves as expected.

When short selling CFDs, there’s no need to borrow the asset itself. Instead, traders speculate directly on price movements – meaning they can potentially benefit from both rising and falling markets.

However, if the price rises instead of falls, losses can accumulate quickly, so short selling carries significant risk. Using tools like stop-loss orders can help manage this.*

*Stop-loss orders are not guaranteed. Guaranteed stop-loss orders incur a fee if activated.

Leverage amplifies both potential gains and losses, increasing overall risk.

Short selling example

For example, if a trader expects Tesla (TSLA) shares to decline, they can open a short position by selling a Tesla CFD.

Let’s say Tesla shares are trading at $1,000. A trader who wants to open a short position on the company’s shares can sell 100 TSLA CFDs at that price.

If the share price falls to $990 and the trader closes 100 TSLA CFDs at this level, they will have made a total profit of $1,000, or $10 per share.

Past performance is not a reliable indicator of future results.

However, markets can be volatile, and prices may move against the position. For example, if the trader sold 100 TSLA CFDs at $1,000 and the price rose to $1,010, they would incur a $1,000 loss.

Past performance is not a reliable indicator of future results.

Benefits and risks of short selling

Trading carries risks, and short selling requires additional caution.

Key risks to consider before entering a short position:

• Since there’s no limit to how much a stock can rise, short selling can, in theory, result in significant losses. Traders may use risk-management tools, such as stop-loss orders, to help limit potential downside.*
• A short seller may have difficulty closing a position if many others are attempting to do the same, or if the shorted stock is thinly traded. This can result in a short squeeze, where prices rise sharply as short sellers rush to close their positions.
• Short sellers, like traders holding a losing long position, also risk liquidation if they fail to maintain the required margin.
• Even if a trader’s reasoning is sound, the price may take time to move as expected, exposing the trader to overnight fees or margin calls.
• Temporary bans on short selling for certain stocks, sectors or markets can also affect open positions.

*Standard stop-loss orders are not guaranteed, while guaranteed stop-loss orders incur a fee if activated.

Short selling can also offer traders potential advantages:

• By taking a short position, traders can speculate on downward price movements, giving them a wider range of trading options in both rising and falling markets.
• Short selling is considered a high-risk strategy that may yield high returns but can also lead to substantial losses.
• 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 can also be used to hedge existing long positions. Hedging aims to protect gains or minimise losses without fully exiting the long position.
• CFD short selling allows traders to gain exposure to market movements with lower initial capital, due to leverage. However, leverage can also increase losses if the market moves unfavourably.

How to limit risks while short selling?

Before short selling, traders should understand the risks of unlimited losses and margin calls. It’s important to assess individual risk tolerance and set clear entry and exit points.

According to financial services company Charles Schwab, traders can use stop orders to help limit losses if the market moves against them.

A stop order is an instruction 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 manage exposure. A stop order automatically triggers a buy-back when the price rises above the stop level. A trailing stop adjusts automatically, maintaining a set distance (by percentage or amount) below the market price.

Types of short selling

There are two main types of short positions: naked and covered.

• Naked short refers to selling securities that have not been borrowed. The SEC banned naked shorting in 2008, though it can still occur due to technical discrepancies in trading systems.

• Covered short refers to selling borrowed securities, usually from a broker, with the obligation to return them later. The trader later repurchases the stock, which is known as ‘covering’ the short position.

Is short selling an effective trading strategy or a risky practice?

The potential for unlimited losses, margin calls, and short squeezes makes short selling a high-risk approach.

With effective risk management, such as the use of stop-losses, traders may view short selling as an additional trading option to participate in bearish markets.

Abusive practices such as spreading false rumours or manipulative selling are illegal. When carried out legitimately, short selling can support market liquidity and help prevent assets from reaching unrealistically high valuations driven by speculation.

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