Short selling guide

Traditionally, investors could only profit from markets that went up in value – but that is no longer the case.

• What is short selling?
• Short selling stocks
• Short selling with derivatives
• Hedging with a short trade
• Risks of shorting

What is short selling?

Short selling is opening a trade that earns a profit when your market falls in price. Most people think of trading as 'buying low and selling high'. While that's a great way to earn profit, it isn't the only one. It's also perfectly possible to 'sell high and buy low'.

To open a sell position, you trade at the bid price instead of the ask. Then, when it is time to close, you buy at the ask – it's the exact opposite of going long.

We covered how to short currencies in the Trading forex lesson. But shorting isn't limited to foreign currencies; you can sell almost any market that you can buy. Let's take a look at short selling shares to see how.

Short selling stocks

When you short sell stocks with a broker, you're selling stocks to open your position. To get around the fact that you don't own those stocks in the first place, your broker will lend you the shares and sell them on your behalf. You'll then get the proceeds credited to your account.

When you close your trade, your broker will use the cash in your account to buy the shares once more. If they are worth less than when you sold them, you'll be able to keep the difference as profit.

Sound confusing? It all becomes much clearer in an example.

• You decide to short Exxon Mobil when its stock is at 33.9/40.1. You tell your broker to sell 50 Exxon Mobil shares at 33.9
• You don't own those shares, so your broker lends them to you and sells them on your behalf. They then credit your account with the proceeds from the sale, which is (50 x $33.9) $1695
• Exxon stock falls to 31.1/31.3, and you close your trade
• To close the position, your broker buys 50 shares at 31.3 using the cash in your account. 50 x 31.3 = $1565, leaving $130 in your account as gross profit

If Exxon Mobil stock had risen instead of falling, you would have incurred a loss. It's also worth noting that your total profit would be less than $130, once commission and borrowing costs are taken into account.

Short selling with derivatives

It can be tricky to find a broker that offers short selling to individual traders. However, you don't have to short sell using this method. Derivatives such as CFDs, where you never own the asset you are trading, enable you to go long or short without borrowing stocks.

Plus, with CFDs you aren't limited to shorting stocks. You can sell any CFD market that you can buy, including forex, commodities, indices, and more.

Opening a short CFD position is the opposite of opening a long one. You decide how many CFDs you want to sell and trade at the bid price. Then, when you want to close, you buy the same number of CFDs at the ask.

Hedging with a short trade

One popular reason to go short is as a means of hedging. Hedging is a form of insurance against negative market moves. When you hedge with a short trade, you're opening a position that earns a profit if an existing long trade incurs a loss.

Say you own several Dow Jones stocks in an investment portfolio but are worried about an impending bear run among US blue-chip stocks – so you sell five Wall Street CFDs. If US stocks do fall, then your losses may be partially offset by the profits from your CFD.

Risks of shorting

When you buy most financial markets, you know precisely what your maximum loss could be. Invest $5000 in gold, for instance, and your biggest risk is that the gold becomes worthless overnight, and you lose your $5000.

When selling, though, there is no limit to how much a market can rise. If you short a stock before the business takes off you may lose your invested capital.

Imagine that you short the stock of a company that has been struggling, with a share price at $50. The best-case scenario is that the company's stock price falls to zero. However – say, if news then breaks that another company is interested in buying it – its price could climb well beyond 100 dollars in a day.

This means that using risk management tools such as stops and limits is crucial when going short. We'll cover these in more detail later in this course.

Shorting may also come with additional costs, to cover the capital that your broker is lending you to open the trade.