What is short selling and why do people use it?

What is short selling?

Short selling isn’t that complicated, especially when you forget about the mechanics behind the trade. Put simply, you ‘sell’ to open a position. If the price goes down, you buy back at a lower price and make a profit. And that’s it – you borrow something and hope the price goes down so you can pocket the difference.

Why do people short sell?

The most straightforward reason is the one you probably expect – to profit from a falling market. But people also use shorting to protect their portfolios and manage risk. Investors often hold assets for the long term and short sell certain markets to lessen the impact of the market’s ever-changing moods.

There’s also hedging. Hedging means lessening risk by taking out a kind of compensation trade. One example of a common hedge is to hold a US dollar position to make sure your US stocks don’t lose value as foreign exchange rates fluctuate.

What markets do people short?

Traders will often short sell a stock even though it has solid fundamentals because they know some markets negatively impact others.

For example, if oil prices are showing a lot of downside risk, they short sell companies like Oil Search, or Santos. Or they short sell a bank or a home builder because they feel we could see a period of negative news around the housing market.

We may even see a period of general risk aversion in global markets, so traders look to ‘short’ a company whose earnings are closely aligned to cyclical downturns in economic growth. In this situation, we tend to see traders hold short positions for quicker periods, as markets often sell off aggressively.

The best time to short-sell a stock

The best time to short sell a stock is when there is increased anxiety and implied volatility in financial markets, with few near-term catalysts to buy.

Temporary hedges

Another tactical use for short selling a share CFD is to temporarily hedge a holding within a share portfolio.

It can be far more cost efficient to simply short sell a CFD (of the same company and the same face value), against the physical shareholding, rather than just closing a core shareholding and buying back at a later date.