Short selling: A complete guide
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Short selling is a trading strategy that focuses on the value of a stock going down rather than up. It can be used for speculation and can be used to hedge risk for a long position in the same stock.
Quick noteThis isn’t for a first-time investor. It’s more complex and risky than traditional investing, so it’s really only suitable for those who have a bit of experience in the field and know their way around this type of trading. Head to our investing page if you’re not quite as experienced.
How to short a stock
When you short sell, you choose a stock that you think will go down in value by a set date.
For example, say you thought that Amazon’s stock price is likely to go down in value – you might choose to short sell the stock.
But, usually to sell something, you’ve got to already own it, right? Not in this case. You can borrow the stock from your provider to sell it, then when you purchase it back later, you can give it back.
You don’t have to hunt for someone to let you borrow their stocks – opening a sell position with a CFD provider will automatically do this for you.
The actual act of short selling is pretty simple. You just need to open up the app or website of your chosen provider, find the stock you want to sell and hit sell. But there’s more to it than that if you don’t want to just lose all of your money. You might come across some terms that you don’t understand, too, that may help you in your journey.
How to short a stock: In summary
- Choose a stock that you think will go down in value.
- Choose a trading provider that lets you short sell – this will be a provider that lets you trade contracts for difference (CFDs).
- Borrow as much of the stock as you want to sell from your trading provider (often this happens in line with the next step).
- Find the stock on your trading provider’s website. You might need the stock code for this. A simple web search of the company name followed by “stocks” can get you this information.
- Open a short position, choosing how much you want to sell.
- Adjust any stop loss or take profit settings.
- Close your position or buy the shares back. If all has gone well, you’ll have bought them back for less than the value that you sold them for, meaning you’ll have made a profit.
What is stop loss and take profit?Stop loss
Stop loss is a tool that can help you protect your investment to some degree. By choosing to use stop loss, you’re effectively instructing the provider to close at a specific rate. You can choose the value that you want it to close on in pounds and pence (or whatever currency it is traded in), or you can choose based on the amount you would lose.
Take profit is the same as stop loss, just the other way around. Here, you enter the value that you want your position to close when it works in your favour. Again, you can choose based on the value of the stock or based on the amount of profit you’ll potentially make.
How to use these features
You might be tempted to make the stop loss just a little bit higher than the stock’s current value and make the take profit miles below the current value (and the opposite when buying). There’s a key reason why this won’t work.
It’s a race. You’re hoping that the stock’s value will get to take profit before it gets to stop loss, but stocks move up and down over a matter of seconds. If you load up a live stock chart and watch it for even a minute, the value will change constantly. The chances of it reaching your stop loss before it reaches your take profit are pretty high.
Example of short selling
Let’s say you want to short Disney stocks. Maybe you think the latest Toy Story film wasn’t as good as the rest and you reckon the price will go down*.
*The latest Toy Story film was great. This is purely hypothetical.
At time of writing, the stock price for Disney is US$124.97. For the sake of an example let’s just round it to US$125.
So you think that in the next week, the price of Disney’s stock will decline in value. You open a sell position for it for, say, 50 shares. You’re now “short” 50 shares of Disney.
You could set a stop loss for, say, US$130 and a take profit of US$120. That means if the stock moves more than $5 in either direction, the position is closed for you. If you’re using a provider with a mobile app, you’ll probably get a notification to let you know. In this example, at US$120, you’ll make a profit and at US$130, you’ll make a loss.
The next part is the waiting game. Usually with investing you should steer clear of looking at your investments all the time, but with this, you’ll want to keep a bit of an eye on it. Don’t sit at your desk at work constantly refreshing the page, though. It’ll waste your time and frustrate the hell out of you.
So you’ve done it – if the stock price does go down, you’ll be able to see approximately how much you’ll have made. A negative movement doesn’t necessarily mean you’ve made money. You need to take into consideration some of the costs involved.
If the negative movement is more than the costs for the trade, you’ve got yourself a profit.
You’ll need to manually close the position, unless you want to wait it out to see if it automatically closes at your stop loss or take profit orders.
What costs are involved?
To short sell, you usually need to trade on margin, which means that you’re borrowing in order to trade. You may need to pay interest on the value of the shares that you borrow while you’ve got a position open.
Sometimes, it might be difficult to get hold of shares to borrow. There may be a fee that is in place for these stocks.
Like margin interest, you might be responsible for covering the dividend payments on the stock to the provider that you’ve borrowed the stocks from.
What are the perfect conditions for short selling?
There are ideal conditions for everything: for surfing, you’re looking for an offshore wind; for figure skating, you want ice as cold as -4°C, and even colder for ice hockey; if you have a monstera, you want it to be in a warm, humid environment. As with watersports, winter sports and plants, there’s an ideal condition for short selling.
Stocks go down quicker than they go up. This means that you want to get in at the right time to actually make some money from it.
The ideal condition for short selling is a bear market.
A bear market is one where the stocks are declining in value – usually by more than 20%. An example of this is the bear market that occurred right at the start of the coronavirus pandemic, where most markets crashed. For short sellers, this was an ideal time to be shorting stocks.
Non-traditional short selling
Borrowing shares from a broker isn’t the only way to short a stock. You can also use:
- Derivatives. Derivatives allow you to speculate on prices without actually owning the shares. You can short sell through spread betting and CFD trading, but be aware that they’re extremely complex and risky financial instruments. Most investors lose money when trading this way.
- Option trading. This is (only slightly) less risky than traditional short selling. You can purchase an option on a stock that allows you to sell it at the initial market price within the option’s expiry date. If the price goes down, you sell, buy back at the new price and make a profit. If the price goes up, you don’t sell at all and only lose the value of the option, thus limiting the risk. With traditional short selling, you can buy back whenever you want (unless the owner of the stock claims it back), whereas options normally have a fairly short expiry date.
Risks of short selling a stock
Repeat after us: short selling is for expert investors and you shouldn’t do it unless you do know what you’re doing.
The reason why it’s considered very risky is that it could make you lose “infinite” money. When you buy a share and “go long”, the maximum you can lose is the amount you invested. When you “go short” instead, there are no theoretical limits to how much share prices could go up, and thus to how much you could lose. Not good.
It’s especially dangerous if a lot of people are short selling shares from the same company and the price unexpectedly goes up. At that point, everyone will start buying back really quickly, causing the stock to go up even more. It’s what’s called a “short squeeze” and it easily becomes a vicious circle that turns out very expensive for short sellers.
Finally, don’t forget that short selling isn’t free. Brokers will charge a fee for lending the stocks, and there are fees for other short selling methods t
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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