What is short-selling?

Short-selling is a way of trading that will return a profit when the market falls in price. When you short-sell, you are selling an asset that you don’t own, in the hope that its price will decrease and you can buy it back for a profit.

Trading
Source: Bloomberg

In that respect, it goes against one of the established tenets of financial trading: buy low, sell high. But by allowing you to profit from bear markets as well as bull runs – or insure against negative price movements affecting your long positions – short-selling is a key part of a successful trader’s toolkit.

How does short-selling work?

Traditional short-selling works by borrowing an asset you want to trade, then immediately selling it on at the current markets price. When you close your trade, you buy the asset back at its new price, and return it to your lender.

Short-selling chart

For instance, say you believe Rio Tinto stock is going to drop in price. You borrow 100 shares via your broker, then sell them for the current market price. If the shares drop down 200p, you can buy 100 shares at the new, lower price, and return them back to your broker to close the trade. You keep the 200p difference per share, making a £200 profit.

However, say your prediction was wrong and Rio Tinto stock increased 200p. If you want to close your trade here and cut your losses, you’d have to buy shares for 200p more than you sold them for – incurring a £200 loss.

Most short-selling takes place on stocks, but you can short many other financial markets, including bonds, forex and cryptocurrencies.

How to short-sell

There are lots of different ways to short-sell a given market. Here’s an introduction to three popular methods: traditional short-selling, CFD trading and spread betting.

Traditional short-selling

Our example above is a traditional short-sell. You borrow an asset – usually stock, and usually via a stockbroker – then sell it on, in essence opening a position where you don’t actually own the underlying asset.

However, traditional short-selling comes with a few limitations. For instance, you’ll need someone to lend you the asset in the first place. So you could encounter issues like unborrowable stock — when there’s no one willing to lend you the asset you want to short.

CFD trading

Like traditional short-selling, when you open a CFD trade you don’t actually own the underlying asset. But with CFD trading, that applies to both long and short trades.

Instead, you are buying a contract to exchange the difference in price of an asset from when your position is opened to when it is closed. When you open your position, you can choose whether you want to profit from a rising market (going long) or a falling one (going short).

Spread betting

With spread betting, again, you never own the underlying market when you trade – regardless of whether you’ve gone long or short.

That’s because a spread bet is a bet on the direction in which a particular market’s price is headed. You choose a certain number of pounds per point when you open your position, and that determines your profit or loss. So a short gold position worth £5 per point would earn you £5 for every point that gold moves down, but lose £5 for every point it goes up.

Why short-sell?

There are two main benefits to opening a position that makes you money when a market drops in price: speculation and hedging.

1. Speculation

The ability to short-sell adds a whole new dimension of market movements to speculate on. Say, for example, that based on your technical analysis you believe that Apple stock is about to head down. An investor who only takes long positions has no way of acting on the opportunity. A trader with access to CFDs or spread betting can act immediately.

2. Hedging 

Hedging offers a way to insure against negative price movements in markets that you have a long position on. For instance, if you hold shares in several stocks featured on the FTSE 100, then a downward move in that index could negatively impact your portfolio. Go short on the FTSE 100, and you may be able to lessen the impact if your British shares start dropping in value.

Disadvantages of short-selling

However, there are several potential problems that you can encounter when short-selling, which can make it much riskier than going long.

1. Unlimited downside

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 potential losses.

2. Short squeezes

If lots of traders have a short position on a stock, its price may suddenly spike. This is most often caused by a positive development for the stock, which can lead a majority of traders to quickly try and close their short positions – this sharp rise in demand in turn causes its price to rise.

3. Dividends

If you buy a stock, you might receive a dividend. If you short-sell a stock and it pays a dividend, you’ll need to pay the equivalent to whoever you borrowed it from. On short CFD and spread betting positions, meanwhile, dividends will be deducted from the funds in your account.

Managing short-selling risk

The increased risks involved in short-selling make effective risk management hugely important. Here are a few tools you can use to limit your risk with IG.

  • Guaranteed stops will close your position once it rises to a certain point, putting an absolute limit on your downside – and you’ll only have to pay a small premium if your stop is triggered
  • Trailing stops will follow your position if it earns a profit, then close it if it reverses by a certain amount
  • Trading alerts will notify you when your market hits a certain level, but let you decide what to do next

Find out more about risk management.

FAQs

What is short interest?

Short interest is a metric that shows what percentage of a company’s total outstanding shares are currently held in short positions. It can be used to determine the overall sentiment that traders currently have on a stock.

Take a look at our market data to see IG client sentiment on stocks, indices, forex pairs and more.

Are put options short-selling?

Yes. Buying a put option gives you the right – but not the obligation – to sell a set amount of an asset at a set price before a set date in the future, and as such gives you a short position on the underlying asset. Other alternative methods of shorting include inverse ETFs, which are designed to move in the opposite direction to their underlying index.

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