You might have heard the term "shorting" a stock, referring to traders and speculators being able to create market opportunities when the price of an asset falls. There might be times when you wish you could personally bet against an asset and potentially benefit from its downturn. If you’ve searched the web and read articles but are still confused about how does shorting work and where the opportunities from a short position may come from, then read on as we demystify this trading technique – once and for all.
Back to Basics: What is a Short?
Let’s begin by explaining the desired result of a short, and then explore how this desired outcome can be achieved. In a conventional (also known as ‘long’) trade, you buy a stock and can sell it in the future when the price goes up. In contrast, a ‘short’ position allows you to create market opportunities if the value of an underlying asset goes down.
How this works is that the trader who wishes to enter a short position ‘borrows’ the securities or other assets of which the trader believes will decrease in value and promises to return them in the future – with a slight premium for their trouble, also known as the borrow-rate.
Upon "borrowing" the assets, the trader sells them at the present market value in hopes of being able to purchase them at a lower cost later If the price of the assets falls subsequently as speculated, it becomes much cheaper to repurchase and return them to the original owner. The trader can thus potentially create opportunities from the fall in price. We should also note that for futures or contracts-for-difference, short positions can be entered into without having to borrow assets from other investors.
An Example of How Short Selling Works Using CFDs
Imagine we have a stock that is trading at $10. As a Contracts-For-Difference (CFD) trader, you believe that the price of this stock will fall. You decide to enter 1,000 SELL contracts at the current price. A week later, the price of the stock falls to $9. You decide to close your trade by executing 1,000 BUY contracts. As a result, you have made a profit of $1,000 ($1 x 1,000 contracts). In this example, transaction costs, borrow-rate costs, and other fees have been omitted.
Why Do Traders Short Sell?
There are two main uses of short sell trades. The first is to take advantage of a bearish market or from anticipated falls in prices. Shorting gives traders yet another instrument they can use to implement a myriad of trading strategies and create opportunities from all market conditions.
The second main use of shorts is as a form of hedge. If a trader observes that their current open positions have departed from their desired risk parameters, entering new short positions allows them to still maintain their positions safely without having to liquidate.
As with all other trading instruments, shorting simply gives traders additional options for them to find and hone their edge in the financial markets.
Risks of Shorting
In a conventional ‘long’ trade, your downside is finite, since the most you can lose is the price at which you bought the asset, should the worst happen and its value falls to zero. However, your potential upside is infinite, since there is theoretically no limit on how high the price of the asset can rise. A short trade, on the other hand, has finite upside and potentially infinite downside. This is because in the best-case scenario, the price of the asset falls to zero, and that is the most you can make from that trade. However, since there is no limit on how high the price of the asset can climb, the risk of loss on a short position is theoretically unlimited. In other words, you may lose significantly more in a short position than a conventional long position.
Thus, when placing short trades, putting a stop-loss is of key importance to properly manage the risks of losing your entire invested capital and beyond.
In Short Selling, Timing is Everything
It is crucial in short selling trades that you aim to get the timing right. This is because, even if you are right about the general price direction of an asset, you could still get wiped out from intermittent swings in prices, which could trigger stop-losses or margin calls. As with all trades, but perhaps even more so for short selling, traders should trade responsibly starting with familiarising themselves with their trading tools and implementing robust risk management protocols in their trading strategy.
