How to short sell stocks

Short selling is a strategy that can be used to take advantage of share prices that are expected to decline. There are a variety of methods that can be used but there are risks involved in the practice too. This makes it important to know how to short sell stocks and which instrument is best suited to your aims.

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Source: Bloomberg

What does shorting a stock mean?

Shorting a stock, or short selling, is a method of trading that seeks to benefit from a decline in the price of a company’s shares.

With conventional investing, you would buy shares that you believe have a positive outlook and the potential for growth – this is known as ‘going long’ or taking a long position. When you short sell or ‘short’ stocks, you’re looking to do the exact opposite. Short sellers identify shares or markets that they think might be poised for a downswing.

Shorting stocks can help traders to hedge against any potential negative movements in markets that they have taken a long position in. It can also provide a means to benefit from bear markets.

Ways to short a stock and examples

There are a variety of methods that can be used to short sell stocks, including share dealing, derivatives and options trading.

To make things easier to understand, let’s say that Rio Tinto shares are currently trading at £40 per share, which you think is overvalued. In anticipation of the share price falling, you decide to short the stock. The outcome would depend on your chosen method of shorting:

Traditional short selling

The traditional method of shorting stocks involves borrowing shares from someone who already owns them and selling them at the current market price – if there is a fall in the market price, the investor can buy back the shares at a lower price, and profit from the change in value.

This is typically a practice of large institutions rather than individual investors, but some brokers will facilitate short selling.

Let’s say that you borrow 100 Rio Tinto shares via your broker and then sell them at the current market price of £40 – taking £4000 from the sale. It is worth noting that you would likely need to pay a fee to borrow a stock to short sell. The shares do fall in price as you predicted, down 200p to £38 per share, and you buy 100 shares back at the new, lower price, for £3800. You then return them to your broker to close the trade and keep the 200p difference per share. You would have made a £200 profit (minus any brokerage fees and dividend costs that are owed).

However, if your prediction was wrong and Rio Tinto stock actually increased 200p, you might decide to close your trade to cut your losses. In that case, you’d have to buy the shares for 200p more than you sold them for – incurring a £200 loss (again before accounting for the borrowing costs and dividends that you would still need to pay).

Derivatives trading

Derivatives are financial instruments that take their price from the underlying market. With derivatives, such as spread bets and CFDs, you haven’t had to borrow shares from a broker – you are simply speculating on the market price rather than taking physical ownership of the asset.

With either method, you won’t need to pay brokerage fees as you don’t take ownership of the underlying shares. With spread betting, you are charged via the spread – the two prices wrapped around the underlying market price – while share CFDs are charged via commission.

  • Spread betting gives you the opportunity to take a bet on the direction in which a particular share price is headed. If you open a short spread bet position, your profit is dependent on the prices going down, giving you the same outcome as a traditional short selling position
  • CFD trading involves purchasing a contract to exchange the difference between the opening and closing price of an asset, in this case a stock. You can use a CFD trade to short sell stocks by opening a position to sell the stock you believe is going to decline in price

Let’s say you had chosen to short sell Rio Tinto shares via CFDs. Rio Tinto is trading at £40, which means that you could open a position to sell 100 share CFDs at £40 (factoring in a 0.10% commission charge), which would give you a market exposure of £4000. As CFDs are leveraged, you would not have to put up the full value of the trade, instead you would only need to put up a deposit – if the margin was 20%, you would put up £800.

If the market did fall as you’d predicted, you would close your position by buying 100 shares at the new price of £35 (factoring the commission charge mentioned above). You would then calculate the difference between the opening price and closing price, and profit from the difference: in this case, £40 – £35 = £5 x 100 shares = £500. Any profit to a CFD trade is calculated using the full value of your exposure, not just the deposit, which means that profits can be magnified.

However, if you had been incorrect and the market increased in price, up to £45, you would have to buy 100 shares at the new market price. This would incur a £500 loss as the calculation is based on the full exposure (£4000 - £4500 = £500 loss).

Options

Options trading is another popular method of shorting stocks. You can buy a put option on the stock that gives you the right (but not the obligation) to sell the underlying shares at a strike price on or before the expiry date.

As Rio Tinto stock is priced at £40, you could buy a put for 100 shares with a strike price of £40. This means that you have the right to sell 100 shares of the stock at a price of £40 per share, no matter how low the market price falls. So, if the stock fell to £38, you could buy 100 shares for £3800 and sell them for £4000 using your put option.

If the share price didn’t fall, you could simply close the position at any time on or before the expiry date, and only lose the premium that you paid to take out the option.

It is important to bear in mind that the life span of an option is limited. Traditional short sales have no expiry date unless the person that you have borrowed the shares from decides to recall their shares, which can happen at any time.

Risks when going short on stocks

Although short selling might seem straight forward, it can be considered risky for a number of reasons:

  • Unlimited loss: theoretically there is the potential for a short position to incur unlimited losses if the underlying stock rises in price instead of falls. However, if you are using derivatives, you can attach stops to your positions to protect yourself
  • Being caught in a ‘short squeeze’: this is what happens when the market price rises and short sellers all rush to exit their positions, driving the price even higher and causing more short sellers to close their positions
  • Unborrowable stocks: there is the potential you may not even be able to find someone willing to lend you the stock to borrow in the first place – known as an unborrowable stock.

Aside from the risks of short selling for the investor, the practice can influence the entire market. If large numbers of market participants decide to short a stock, their collective actions can have a huge impact on the share price of the company. It is not unknown for investors to be banned from short selling. For example, during the 2008 financial crisis, there was a ban on shorting the shares of certain banks and financial institutions.

Summary

  • Short selling is the practice of borrowing shares, in order to sell them at the current market value and buy them back once the market has declined – profiting from any difference in price
  • Shorting can be used for hedging and speculative purposes
  • The traditional method of short selling involves borrowing stocks that you do not own, usually via a stockbroker
  • Alternative methods of short selling stocks include CFD trading, spread betting and options trading
  • There are risks involved in short selling stocks, such as unlimited loss, being caught in a short squeeze and unborrowable stocks.

If you want to practice short selling stocks in a risk-free environment, you can open a demo account with IG and start testing your CFD trading, spread betting and options trading. Or, if you feel ready to start short selling stocks on live markets, you can open an account and be ready to trade in less than five minutes.

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