Nuts and bolts
Short selling means selling an asset at a higher price and then buying it back at a lower price. The strategy is primarily used for both speculation and hedging. Speculators seek ways to capitalise on decline, hedgers try to protect their portfolio and mitigate losses.
Going short is considered psychologically challenging for a trader as it involves borrowing – a trader aims to sell a stock that he doesn’t own. This is the backbone concept of short selling. You borrow an asset and sell it at the actual market price.
If the price goes down, you buy it back again and return it to the lender. The difference between the sell price and the buy price is your profit or loss.
Conversely, taking a long position is a lot easier to understand and control. It doesn’t require as much emotional energy as the market behaviour is usually slow and more or less predictable. Rising is steady and gradual, whereas falling is fast and frenetic.
However, if you get the hang of short selling, you will get more opportunities to make money in various market conditions.
The biggest advantage
To short via a CFD, a trader takes advantage of a very convenient feature – leverage. A trader puts up only a fraction of the total value of the position they plan to open. The rest of the money is offered by a CFD provider.
If a broker offers a 1:2 leverage, a trader will be able to handle amounts 50% bigger than his deposit. $500 on his trading account to start will turn into $1000 as the broker will ‘borrow’ you another $500.
Let’s take a look at the example.
Imagine you want to trade CFDs on 5 BTC, which are trading at $10,000 (bid)/$10,100(ask) price. You decide to short it and sell 5 CFDs at the bid price of $10,000. Your broker offers a 1:2 leverage, so you have to deposit 50%, or $25,000.
Over the next two hours the price falls. Bitcoin is hovering at $8,000/$8,100 now. You buy it back at the ask price of $8,100 or cover your short position. The price moved $1,900 ($10,000 – $8,100) to your advantage. To calculate your profit, multiply the sum by the size of your position:
Tips to bear in mind when short selling
Choose your moment
A short trader needs to pick the right time to place a trade. If you join the falling trend too late, the asset may already have declined greatly by that time. And vice versa, if you short sell in advance, there is still a high chance it may jump in value.
Go short during a bear market
A short seller thrives in times of decline. The bear market of 2008–2009 was a pot of gold for short traders. Still, there are points to consider. When prices go up, they do so gradually. Traders have enough time to take advantage of the bullish market.
Alternatively, the bear market is quick and fierce. When prices go down, they do it in a matter of moments.
Never neglect watching the calendar, otherwise you risk falling prey to bullish seasonality. If you set out to short sell during a holiday period, brace yourself for losses. Markets in these times don’t follow their natural pattern, there is not enough supply and demand.
Avoid the strongest stocks
High securities are always thought as perfect instruments to short sell as they are ready to fall to earth. A better way to short sell is to pay attention to weak stocks and apply the countertrend bounces to make profits.
Also, traders tend to sell stocks that have a legendary background or an interesting story. Such assets instantly spark the interest of a big crowd. As a result, these stocks remain high even in times of downtrends.
Sell a pullback during a decline
Pullback is a brief drop in prices that takes place when the market follows an upward trend. This short price movement often entails a downtrend which, in its turn, offers a wealth of selling opportunities for short traders. The most important task here is to define the main trend.
Use stop losses
Stop losses are meant to safeguard your funds if the market goes against you. Even if your position becomes unfavourable, stop loss mitigates the risks and won’t let you suffer dramatic losses.
Short selling works extremely well in a bearish environment. 'Trend is your friend' is the rule of thumb if you plan to make profits on a decline.
However, following the downward trend can be a recipe for disaster. Short sellers are often trapped in squeezes when stock prices skyrocket and the purchase volume suddenly spikes. This is because traders close their positions and seek to cut losses.
Like many other trading strategies, short selling involves significant risks and requires perfect timing. Entering the bearish territory too late or too early will result in no good. Bearing in mind all the risks and pitfalls, short selling opens a bunch of opportunities to make profit in various market times.
Trading CFDs involves significant risk of loss.
To learn how short selling can work for your trading strategy watch our video: