A Short Guide to Short Selling

Short selling is an investment strategy where an investor sells a security or stock and buys it back in the future with the hope that the price has gone down. Sell high and buy low. This is effectively the opposite approach from a long investment approach, which is buying a stock and hoping that its value increases over time. Buy low and sell high.

Contract for difference (CFD) is a popular form of trading. The reason for this is because with CFDs, you can buy and sell portions (units) of a stock without owning the underlying asset. This gives traders greater freedom to manage risks in their portfolio, and allows for a more strategic approach to short selling when speculating the trends of the market.

But what is short selling, and how does it work? Our beginner’s guide should answer any questions you have.

What is Short Selling?

Short selling, or shorting as it is sometimes referred to, often involves the process of selling borrowed stock. One way these can be obtained is from a broker, who will search for the stock and sell it on your behalf at the current value of the security. When the price has declined, they then buy back the stock and return it to the lender.

It is essentially selling a stock and speculating that it will decline in value. It is a risky way to profit from declining stock prices.

How does it work?

Short sellers are effectively betting that the stock they have sold will drop in price. If the stock does indeed decline after selling, the shorter buys the stock back at a lower price. This difference between the price the stock was initially sold at and the new buying price is the profit.

The process of buying back the stock once the price has declined is called covering your short. You will be able to return the borrowed stock and keep whatever money is left over, therefore protecting yourself from potential losses and making a quick short-term profit.

Investors who are looking to short sell do so to capitalise on a declining stock, whereas banks and hedgers go short in order to protect their gains or to minimise losses.

Pros and Cons of Short Selling

One benefit of short selling is the possibility of high profits. If your speculation is correct and the stock does decrease in value, you can stand to make a decent profit. Also, as this is typically borrowed stock, the initial capital from investors can be very little. This means that leveraged investments can be used and can also be hedged against other holdings of your portfolio.

In many ways your investment is protected. The most you can stand to lose when shorting a stock is the amount you sell it for, as long as the price decreases in value as predicted.

Shorting stock is mainly for advanced traders because it can be extremely risky. There is theoretically no limit to the amount an investor can lose because the stock can continue to increase in value indefinitely. There are even some cases where investors can end up owing money to their brokerage because they have shorted and the stock continues to increase in value instead of decrease.

There are also many costs and fees to consider when shorting stock. These fees are not included in the traditional long investment approach and can quickly outweigh the benefits of shorting.

Ultimately you must conduct as much market research as possible and seek advice where applicable on shorting stocks and whether that is the best option for you.