Summary: Shorting is when a trader sells an asset that they do not own, so that they can buy it back at a lower price. When spread betting, investors will short using a ‘down bet’ and sell a security until they plan to buy it back when the price has fallen.
What is Shorting?
Short-selling or shorting in finance refers to the practice of selling an asset that is not owned by the seller. A short-seller borrows the asset and sells it in anticipation of lower prices in the future. Once the prices drop, the short-seller would buy the asset at a lower price and return it to the lender, making a profit on the difference between the selling price and the buying price.
Short selling may be incentivised by speculation if market analysis shows that a stock’s price could fall in the coming period, or by the desire to hedge a long position in the same security in order to reduce downside risks.
If you’re wondering what is the difference between shorting and longing, let’s cover this quickly in the following lines. Short-selling is practically the opposite from “going long”, whereby a trader profits from an increase in the price of the bought asset. Shorting and longing work close together, as both provide the liquidity needed to buy or sell a stock on the market. If a trader wants to buy a stock at $10, his or her order will likely be matched with the order of the short-seller who wants to sell the stock at $10, and vice-versa.
Let’s explain short selling with the following example
A trader believes that stock ABC may drop in price because of weaker company sales and lower profitability. If the stock currently trades at $100, the trader may short-sell the stock in order to profit from the expected fall in price. To short-sell the stock, the trader would borrow the shares from his broker and sell them at the current market price of $100. If the price of the stock drops to $75 after a few days, the trader could buy the shares at $75 and return the borrowed stocks to his broker. In this example, the trader would have made a profit of $25 per share.
However, let’s say that our trader’s analysis proved false and the stock’s price rose to $115 per share. If the trader decided to close the short position at $115, he or she would actually make a loss of $15 per share.
Mechanics of Short-Selling
In essence, short selling consists of the following steps:
- The trader sends the broker a short-sell order, with the proceeds credited to the broker’s account. The trader doesn’t earn any interest or dividends on the shorted assets.
- If the price drops, the trader may decide to buy the borrowed shares (cover the short position) to make a profit on the difference between the selling and buying price. If the price rises, the trader would make a loss.
- The trader returns the borrowed shares to the broker
- At any time, the lender of the shares may call for the return of them. The trader (borrower) needs to cover the short position or borrow the shares from elsewhere to return them to the lender. If the broker executes this transaction automatically, it’s called a “buy-in.
Short Selling Strategies: Put Options
A popular short selling strategy involves the use of put options. A put option gives the holder the right to sell the underlying security at the put strike price, on or before the option’s expiration. If the stock’s price starts to fall, the put option will increase in value, and the option’s holder may decide to execute the contract and profit from the difference between the current market price and the put’s strike price. Put options also allow to short-sell a range of different asset classes by using bond options, currency options or commodity options, for example.
What is the Danger of Shorting a Stock?
Short-selling carries certain risks which every trader should know about. When short-selling a stock, the potential profit is always limited, since the most a stock can decline to is $0. On the opposite, the potential loss is theoretically unlimited if the stock is in an uptrend. Using put options significantly minimises these risks, as the only loss a trader can incur if the stock’s price starts to rise is the option’s premium.
Other Trading Basics
A Bear Market occurs when the price of a security is falling, and the negative outlook of the security causes the security’s price to continue to fall, causing a self-sustaining problem.
For a downturn like this to be officially considered a bear market, it must be on-going for longer than two months, otherwise it is known as a correction.
Bears are generally traders with a pessimistic view on markets that look to profit from a decline in prices.
Learn the skills needed to trade the markets on our Trading for Beginners course.