Short selling is a means of trading when you think the price of an asset is going to fall. It turns conventional investing on its head in that you sell before you buy. And many new instruments, such as contracts for difference (CFDs), have made shorting an asset easier.
You can now short an asset on a mobile trading app by simply hitting the sell button when you think the asset price is about to drop or when it is already dropping.
But be warned: speculating by going short is a high-risk activity. It typically has a short-term time horizon and you need to watch out for the price turning around and rising again.
Contracts for difference (CFDs)
Short selling has been around for about 500 years, but the more modern way to short an asset is via contracts for difference or CFDs.
CFDs are a type of derivative that mirror the performance of a share, index, currency pair or commodity price. They can easily be accessed from a mobile phone or tablet and are available whenever the markets are open.
A CFD is an agreement between the trader and the provider to exchange the difference in value of the share or other assets at the start of the contract (open position) and the end of the contract (close position). This is usually a fixed period and often just within one day's trading - there are usually extra costs to holding a CFD overnight.
Using CFDs you can sell ABC Car Company at £10 and buy it back at £9 just as you can with the shares, only with CFDs there is no need to borrow the shares before you sell them - as you must do with traditional short selling. That also means there is no corresponding fee to do that.
CFDs also have the advantage of not attracting stamp duty, which trading the physical stocks and shares does.
Leverage is a key feature of CFD trading. It means that you only have to tie up a small percentage of your total position. Say you have £1,000 to invest and there is leverage of 10:1 you could invest the equivalent of £10,000.
If all goes well your investment is 10 times as profitable. If it doesn't go well, your losses are magnified 10 fold.
The scale of potential losses can be capped by having a stop loss order on the deal to stop it at a predetermined point.
Short selling usually needs a margin account. This has two elements
- Maintenance margin - the amount overall you can risk in all your trades
- Deposit margin - the percentage of the full value of the trade for that particular asset
If the trade doesn't go as well as you'd hoped, you could lose not just your deposit margin but eat into your maintenance margin.
If the funds in your account are insufficient, the provider will require them to be topped up. This is known as a margin call.
Margin calls can happen when your losses are at 20% of your maintenance margin. At 50%, your trades will be closed as quickly as possible to try to stem your losses. But you risk losing all you have deposited and more (unless your broker guarantees that will never happen).
Shorting the CFD markets
With CFD trading the deposit margin is the percentage you have to pay to open the contract. The percentage will vary depending on the volatility of whatever is being shorted. For example the margin on a highly volatile asset, such as Bitcoin, can be as much as 50% during its most volatile periods, while on blue chip shares it may be as little as 2%.
You short 1,000 CFDs at £10 a share. The margin on the shares is 10% so you pay just £1,000 instead of £10,000.
The shares fall to £6 and you end the contract. You have made £4,000 profit minus any fees.
If, however, the share price rose £2 you would end the contract with the shares at £12 and you would lose £2,000 on the contract.
You must to be able to settle this amount from your maintenance margin account. That means your maintenance account would need to have at least £10,000 in it and you'd be close to a margin call. However, if you had other trades that were successful and your overall net loss was, say £500, you'd be OK.
Note: Short selling CFDs without leverage and margin will soon be possible on the capital.com trading app.
Stop loss orders
One way of protecting yourself from losses is to have a stop loss order in place. These work for both going long and short. Going short you place a stop loss order to trigger if the price moves against you - starts to go long, or rise instead of fall.
In our example, you might set a stop loss order at £10.25. This would begin exiting as soon as the price hit £10.25, ideally capping your losses at £250.
You can also have trailing stops, so that as your short position proves successful a new stop loss level is placed to prevent any rise in the price wiping out your gains. Stop loss orders are well worth considering.
Not just shares
Even if the trend is upward, few prices rise on a smooth curve and there are often significant falls in price that a short seller can capitalise on.
For example on 20 December 2017 you could have taken advantage of a dip in the NASDAQ 100 when it fell 25 points in morning trading before continuing on its general upward direction.
But short selling started with traditional shares.
Traditional short selling of shares
The conventional way of investing in shares is to buy them and then hold on to them until they rise to a price at which you are happy to sell them. This is fine if the price will be higher in the long run. This is known as long selling.
But shares don't always increase in price. What if there is a fair chance that the share price will fall, perhaps because some bad news about the company is about to come to light?
This is where short selling can be a valuable investment tool. You are still aiming to buy low and sell high, but just in the reverse order - you sell the shares at the high price first and buy them back at a suitable lower price later.