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).
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
As CFDs mirror the price of stock market indices, currency pairs, commodity prices and cryptocurrencies, as well as shares, you can go short on these as well.
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
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.
Short selling used by Investment traders - hedging - to lower risk and generally has a long-term time.
How short selling works
How, you may ask, can you sell shares that you don't own? You borrow them from a broker - for a fee - and then sell them.
Then when the share price reaches a level you are happy with you buy them back and return them to their original owner.
The difference between the purchase price and the sale price is your profit (or loss if things haven't gone to plan). You will also pay a fee to the broker who lent the shares.
Remember: short selling CFDs avoids having to borrow the shares and avoids the fees to the broker. It is all done by clicking the sell button.
Say you have heard more and more reports of a problem with a particular make of car. You think a large-scale recall is a real possibility. This will have an adverse effect on the share price.
For example, Nissan's share price fell by 5% in October 2017 when it announced that it was recalling 1.2 million vehicles in Japan due to final inspections not being carried out properly.
So you sell 10,000 shares of the ABC Car Company at £10 a share. A week later news breaks that it is indeed recalling thousands of vehicles to fix a fault.
The share price drops to £9. You buy 10,000 shares. You now have a gross profit of £10,000 as you bought the shares for £90,000 and sold them for £100,000.
Upsides of short selling
Short selling's questionable reputation is not totally deserved and, used well, it has its advantages:
- Bad news might not be factored into the current price of the stock because, naturally, companies are much more forthcoming with good news about their business than bad news
- When markets and stock prices fall it is often at a quicker rate than they rise at
- An overpriced stock may fall to a more realistic value after research by short sellers
- It helps the liquidity of the market
- Short selling enables traders to profit from falls in price, not just rises
Downsides of short selling
There are things to bear in mind:
- There is no limit on the amount you can lose if the share price goes up not down
- You have to pay any dividends due on the shares back to the original owner when you have shorted them
- The trend of the market is usually upward and you will need to buy the shares back at some point
- There is the risk of a short squeeze where the broker asks for the shares back and you have to buy them back at a price that may not be advantageous
- The cost of borrowing the shares can be high
- The expected catalyst for the price fall may not happen or take longer to happen than you had hoped
It is not just one-off events that can send a share price down. Short sellers also look at companies that:
- rely too much on one product
- are making the most of the latest fad or fashion
- are threatened by new competition
- have poor financials such as lack of cash flow
- have price earnings ratios out of step with their growth rates
Seeing what other people are doing is another way of looking for companies whose share price may be about to fall.
Shorted holdings of 0.5% or more of the issued share capital of a company have to be registered with the Financial Conduct Authority.
IHS Markit publishes lists of the amount of stock that is out on loan at any given time. For example, ahead of its interim results in September 2017 nearly 30% of the stock of troubled construction company Carillion was shorted.
When the results were announced Carillion's stock price fell by 20%. Several companies were shorting Carillion shares before the company went into receivership.
As well as speculative investing, short selling can be used for hedging - insurance purposes. Say you have shares in a company that you want to keep long term but you know the industry is about to go through a bit of a tricky patch.
You hold on to the shares but short a similar amount using CFDs so the profit on the short will offset the short-term dip in share price in your long-term investments.
For example, you have 10,000 shares in XYZ bank. Its share price falls from £5 to £4 meaning your investment falls from £50,000 to £40,000. If you could short 10,000 CFDs in the same shares at £5, anticipating the price drop, and buy them back at £4 you would have covered the fall in price.
You would do this using CFDs of XYZ shares, not by shorting the actual shares.
Short selling tends to hit the headlines for the wrong reasons. It is one thing to wait for the price to go down naturally; it is somewhat different to make the price go down yourself to your own advantage.
If a lot of stock starts to be shorted it can create uncertainty about the financial health of a company. In the financial crisis of 2007-08 short sellers were accused of driving companies such as Lehman Brothers out of business.
To counter this, the FCA can impose bans on the short selling of certain stocks.
Short selling is far from a new concept. The earliest example is thought to have occurred in the Netherlands in the early 17th century when Isaac Le Maire, a wealthy Dutch businessman, sold shares in the Dutch East India Company.
Le Maire had a questionable motive though as he was a former director of the company and held a grudge against it. He first tried to set up a competitor trading company and when that failed he started spreading rumours about the company to try to send the share price down.
But the share price rose and Le Maire lost a significant amount of money.
Be warned: Short selling does not always work. You risk losing if the share price rises.
While long selling is often about investment, short selling is much more about timing. Time that sale and purchase back right and short selling can be a valuable addition to your investing armoury.
Time it well with leverage and the gains can be even better.