Usually, when investing, you expect to profit from strong performance. However, there is a whole other class of traders, known as “shorts”, who do just the opposite to receive rather high returns. How? Let’s dive in and figure out what shorting is and how it works.
What is shorting?
Shorting, also known as short selling or going short, is an act of selling an asset at a given price without owning it and buying it back later at a lower price. Simply put, if you have a reason to believe that some financial instrument is about to depreciate in value, you can make money by borrowing it to sell at the current market price and repurchase it when the price goes down. The price differential between the two actions is your profit or loss.
The concept of shorting has been around for quite some time. In fact, the first person who attempted to short a stock was Isaac Le Maire, a Dutch trader. In the 17th century, he bought shares of the Dutch East India Company, expecting competition to drop its price significantly. In fact, that never happened: the shares went up, and Le Maire had to leave Amsterdam as he got caught lying to artificially decline the stock’s price.
How does shorting work?
Now, you may wonder, how can you sell something if you don’t actually own it? It’s not as difficult as it seems. In order to perform short selling, you have to borrow an asset first (for the sake of explanation, let’s talk about a stock). Typically, it is done through a broker. You open a margin account, and he loans you a stock owned by another trader or by the brokerage itself.
Then, the borrowed stock should be sold straight away. Once sold, you start waiting for it to go down in price. When you’re ready to exit your short position, you buy the stock back in the market at a bargain. This repurchased stock is later returned to the broker to pay the loan. The price differential between the selling and rebuying is your profit or loss – excluding interest and commissions.
Borrow cost should also be considered. It is the fee you pay to your broker for borrowing the stock. The cost of it is usually minor compared to fees paid and interest accrued. It’s also important to keep in mind that as the stock is borrowed, the lender gets the dividends. Therefore, you must pay the fee plus any dividend received when returning the stock to the broker.
Shorting is usually done with financial instruments traded in public securities, currency or futures markets. You have a variety of options to choose from, including stocks, commodity futures of all types, bonds, forex and CFDs.
Pros and cons of the shorting strategy
The main disadvantage of the shorting strategy is that the risk is theoretically infinite. If the market goes against you, there’s no limit to how high the price can go and how severe your losses will be. That is why it is important to have a thought-out strategy and be aware of the risks.
Nevertheless, shorting stays extremely popular among many traders. And here’s why:
- It allows you to potentially reap large earnings;
- It gives you the opportunity to survive and profit in a bear market;
- It can be employed on multiple financial tools and assets. Due to the rise of derivative products and online trading, you can take a short position on hundreds of markets;
- It can be used in a speculative manner or for hedging purposes.
A contract for difference (CFD) is a favoured derivative product for short selling. With CFDs, you trade the price of an asset rather than the asset itself, so you don’t have to deal with the complexity of the actual shares. Additionally, if you trade with CFDs, you enjoy the benefits of leverage while shorting, meaning you get an opportunity to take larger positions than you could normally afford with your initial capital.
Now, with shorting explained, you can learn more about CFDs trading with our free online courses.