Short-selling is the term for a trade that makes a profit when the market in question falls in price.
It goes against one of the key tenets associated with financial trading: buy low and sell high. Instead, a short-seller will try to buy high and sell low.
How does short-selling work?
When you short-sell, you are in effect borrowing the asset you are trading from your broker. For instance, if you believe Rio Tinto shares are going to drop in price you can borrow 100 shares from your broker, then sell them for the current market price. If they then drop in value, you can buy 100 shares at the new, lower price, and return them back to your broker for a profit.
Derivatives like CFDs make short selling a lot simpler. Because you never own the asset you are trading, going short with these derivatives is as easy as going long.
Making a short trade offers the opportunity to make trades in markets heading downwards as well as upwards. On top of this, it can also be a great way of hedging.
For example, if you hold shares in several stocks featured on the Nikkei 225, then a downward move in that index could negatively impact your portfolio. Go short on the Nikkei 225, and you may be able to lessen the impact if your Japanese shares start dropping in value.
However, these opportunities carry with them a significant risk. When you buy an asset, the maximum risk of your trade is that the asset’s price drops to zero and you lose your investment. When you sell an asset, its price could rise infinitely so there is no cap on your losses.
For this reason risk management tools, such as stops, can be useful when short-selling.