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Short selling enables traders to profit in a down market or protect existing investments. Find out how and why short selling can become a key part of a balanced trading strategy.
In the same way that prices can rise, they can fall. Short-selling allows you to trade on a market no matter which direction it is heading. Reasons for short-selling include:
To profit in a bearish market
Short-selling provides a way to speculate if you think a market’s value is going to decline. This allows you to add value to your portfolio even in a bear market. Without short-selling, it can be very difficult to make money from a downbeat market.
Sometimes economic events or published financial problems can lead to a decline in the value of a company. Short-sellers tend to look out for these fluctuations in the market, hoping to make a profit as the price dips.
To protect another investment or portfolio
If you hold a number of long positions, you may choose to protect them with short positions. This is known as hedging.
For example, if you own a selection of stocks from the FTSE 100, you might use a derivative contract to hold a short position on the FTSE index as a whole, in case of adverse movements against your portfolio.
The benefit of hedging is that it allows you to minimise your portfolio risk – just like taking out an insurance policy on your house or car. Hedging is different from speculation, as the intention is to reduce risk rather than increase it.
Let’s say that you own a portfolio of FTSE blue chip stocks worth £60,000. You expect their share price to rise, so your position is speculative.
You decide to hedge against the risk that they may not rise by taking on a position short-selling the FTSE Future. The FTSE future is trading at 6000.
You short-sell a contract of the FTSE 100, where a 1-point movement in the index is worth £10. So, by short-selling the FTSE at 6000 you have a short position of £60,000 which ties up with your portfolio value.
A few days later, negative news about the financial sector causes share prices to fall significantly. The FTSE 100 drops 10%. All the major blue chips lose value. Let’s look at the value of your trades:
FTSE blue chips:
Initial value: £60,000
End value: £54,000
Sold short at 6000
Currently at 5400
£60,000 - £54,000
600 points x £10/point
= £6000 profit
As the market has dropped 10%, you have lost £6000 on your portfolio. However, you could buy back the FTSE short for a 600-point profit (which translates in this example to £6000).
Without the hedge, you would have lost £6000 on your long position. Because the portfolio was hedged, it offset the loss.
Please bear in mind that it is unlikely in the real world that your portfolio would move exactly the same percentage as the FTSE 100 index.
There are limitations to selling short, and it is important that you fully understand these before considering short-selling in your overall trading profile.
Theoretically, there isn’t a limit to the amount of money you could lose. If you were going long, your maximum loss would be capped when the asset reached flat zero in value. When shorting a stock, however, the price could theoretically keep rising forever.
You might want to consider adding a stop-loss to your position to ensure that your maximum potential loss is capped.
You won’t benefit from stock dividend payments, as you are effectively betting against the stock without owning it. In fact the lender still owns the stock, so you’ll need to pay them any dividends declared during the time the stock is loaned to you. Other corporate actions – such as stock splits or bonuses, for example – will also be priced into your short position.
When trading shares or futures, there can be times when it is not possible to short sell, and regulators will declare these unborrowable for economic reasons.
For example, if a lot of people were to short sell stocks from a certain sector, like banking, this would affect public confidence as it suggests that traders think the share price is likely to fall. So stockholders would be encouraged to sell their stock, driving the price of the asset down.
Stocks are also unborrowable if nobody currently holding those stocks is willing to lend.