Short-selling goes against the traditional mantra of buying low and selling high. But it can be a useful tool, helping traders to find opportunities even in falling markets. Short-selling is a trading strategy where a trader speculates on the decline in a security’s price and attempts to profit from the realisation of an expected decline. It’s also referred to as “going short”, “selling short” or “shorting” the market.
In this article, we will learn more about short selling. We will explore various short-selling strategies, view how CFD short-selling works and find out about the potential risks and benefits of this trading technique.
What is Short-Selling?
Short-selling, also referred to as shorting or going short, is a trading strategy employed by traders to profit from declining markets. In this strategy, traders sell borrowed assets with the expectation that their prices will decrease. Later, they aim to buy back the assets at a lower price, generating a profit from the price difference.
While short-selling is predominantly associated with shares, it can be applied to various other financial markets, including forex, indices, and cryptocurrencies. Shorting Bitcoin, in particular, has gained popularity in the cryptocurrency market.
How Does Short-Selling Work?
Short-selling is a trading strategy that involves borrowing the underlying asset from a broker and immediately selling it at the current market price. In this process, the trader does not actually own the asset, and they may need to pay a lender’s fee for the borrowed asset. When the trader decides to close the trade, they must repurchase the asset at its new price and return it to the lender. The profitability of short-selling depends on the market’s movement – if the market price falls, the trader can make a profit, but if it rises, they will have to buy back the asset at a higher price, resulting in a loss.
However, traditional short-selling has its limitations. Since the trader needs to borrow the assets, they may encounter issues like an “unborrowable stock,” where no one is willing to lend the shares.
An alternative approach to short-selling involves using derivative products, such as Contracts for Difference (CFDs). With CFD trading, the trader does not exchange the underlying asset itself. Instead, they agree to exchange the difference in the price of the chosen asset from the time the position is opened to when it is closed. Short-selling a CFD involves opening a position to ‘sell’ the asset. For example, if Apple shares are trading at $150 per share, and the trader short-sells 100 CFDs, they could close their position when the price reaches $145 per share, resulting in a profit of $500 [($150 – $145) x 100]. This way, CFDs offer an efficient and flexible way to execute short-selling trades without the need for physical ownership of the underlying asset.
Short-Selling Example
Let’s consider an example of short-selling with Bitcoin:
Suppose the current trading price of Bitcoin is $3500, but you anticipate a decline in its price. In response, you decide to initiate a short position by selling 10 Bitcoin. A week later, the Bitcoin price drops to $3400, and you decide to close your position. As a result, you earn a profit of $1000.
This profit is calculated by taking the difference between the opening price and the closing price of the asset and then multiplying it by the number of Bitcoin traded: [($3500 – $3400) x 10].
However, it’s essential to recognize that short-selling carries risks. If the price of Bitcoin were to rise instead, for instance, reaching $3550, you would incur a loss of $500.
Risks and Benefits of Short Selling in Trading
Trading involves inherent risks, and short selling carries its own set of precautions. Here are some important risks to consider before making any trading decisions:
1. Unlimited Losses
Short selling can result in unlimited losses for the trader since there is no ceiling to how much a stock can gain. However, risk management tools like stop-loss orders can be utilized to limit potential losses.
2. Difficulty in Closing Positions
Short sellers may encounter challenges when trying to close their short positions, especially if many others are attempting to do the same or if the stock being shorted has low liquidity. This situation can lead to a short squeeze, causing a sudden jump in prices and increased losses for short sellers.
3. Risk of Liquidation
Like traders holding losing buy positions, short sellers also risk the liquidation of their positions if they fail to meet minimum maintenance requirements.
4. Time Frame and Fees
Even with a valid rationale for shorting a stock, it may take time for the stock price to decline. In the meantime, short sellers may face risks of margin calls and overnight fees.
5. Short Selling Bans
Bans on short selling for specific stocks, sectors, or entire markets to prevent unwarranted selling pressure can adversely affect open short positions.
However, short selling also offers traders certain advantages:
1. Speculate on Downward Price Movement
By taking a short position, traders can speculate on potential downward price movements of an asset, expanding their trading options to benefit from both bullish and bearish markets.
2. Hedging Long Positions
Short selling can be used to hedge long positions, aiming to protect gains or minimize losses. Traders may take up short positions to limit losses without exiting their long stock positions.
3. Flexibility and High-Reward Potential
Short selling is considered a high-risk, high-reward trading strategy, providing traders with greater flexibility and potential for substantial profits.
4. Leverage in CFD Short Selling
CFD short selling allows traders to achieve higher profits using lower initial capital due to leverage. However, it is essential to be cautious, as leverage can also amplify losses if the market moves against the trader.
In conclusion, short selling can be a valuable tool for traders seeking to profit from declining markets, but it comes with significant risks. Understanding and managing these risks, along with considering the potential benefits, is crucial for making informed and successful trading decisions.
Is Short Selling a Viable Trading Strategy or a Risky Undertaking?
The presence of potentially unlimited losses, margin calls, and short squeezes makes short selling a risky trading strategy. However, when traders are well-informed about risk management tools, such as stop-loss orders, they may view short selling as an additional opportunity for trading, allowing them to speculate on bearish markets.
It is essential to note that abusive short-selling practices, such as spreading false rumours and orchestrating bear raids to manipulate stock prices downward, are illegal. When executed correctly, short selling can serve as a strategy for portfolio risk management.
Moreover, short selling plays a crucial role in providing liquidity to markets and has the potential to prevent stocks from inflating to unjustifiably high levels due to excessive optimism or hype. By acting as a counterbalance, short selling contributes to maintaining market stability.
Author Bio: Andrea Ollero, a writer and market analyst, has 5 years of expertise in writing beginner-friendly trading techniques, tutorials, and advice. Also, she suggests FP Markets as the top broker for trading CFDs and forex.
