Short selling as a way to profit
Investors in the financial markets buy and sell securities with the overall aim of making a profit. Assuming an investor buys a financial asset and then sells later at a higher price thereby earning a profit, the process is referred to as ‘going long’. Conversely, an investor is short selling or shorting when he aims to profit from the declining values of securities usually borrowed from the broker. Though it seems like a lucrative trading style, it is very risky.
Short selling originated from the stock market and it is still practiced today in stock trading and other financial markets. Its history can be traced back to the 17th century when a Dutch trader known a ‘Isaac Le Maire’ shorted the shares of the Dutch East India company and bought them back at a profit. Over the years, the strategy spread but has faced many challenges and bans from different regulatory authorities. It has often been despised and regarded as unethical.
Short selling Stocks
Speculators use this strategy to take advantage of predicted declines in the stocks of quoted companies. The process involved in shorting a stock is as follows:
- Carry out your analysis and determine the company stocks about the decline.
- Borrow the relevant stocks from your broker or anyone that owns them.
- Sell the stocks in the stock market.
- Monitor the stock prices as it declines.
- When satisfied, try to buy back the stocks at the lower prices.
If things work out as predicted, the short seller buys back the stocks, return what was borrowed and keep the profits, however, if predicted wrong it will result in loss. There is usually a fee payable to the lender which is like an interest for borrowing.
Short Selling CFDs
Contract for Differences (CFDs) are agreements made between two parties; to pay each other the price difference of an asset for the contract duration without ownership claims. CFD contracts are usually between a trader and a financial service provider; who offers the tradable CFD assets as well as the infrastructure and trading platforms. The trader only speculates on the prices of the assets but holds no assets. CFDs are available in different markets including stocks, cryptocurrencies, bonds, indices, commodities, Exchange traded funds (ETFs), etc.
CFDs are derivatives; meaning that its prices depends on the underlying assets, for instance Bitcoin CFD price mirrors the actual price of Bitcoin in real time. On the CFD trading platforms, the financial service provider quotes two prices for each asset; the bid and ask prices. The trader only places a ‘buy’ or ‘sell’ trade depending on his analysis and forecasts. The contract is complete when he closes the trade which locks-in the profits or losses.
For short selling CFDs, the trader only needs to deposit a small percentage of the total amount required before opening trades. For example, on a margin of 5%, a CFD trader only needs to deposit $50 in order to open trade positions worth $1,000. So, it is like the CFD trader is already trading with borrowed funds. Trading on leverage is very risky as the trader can lose all his invested capital.
To short his position, the trader targets a bearish or declining market and then places a ‘sell’ order. If he is right and the price declines, he will make a profit from the price difference when the order is closed. But, if he is wrong, he suffers a loss which is equal to the price difference.
Short selling CFDs with r1investing
r1investing is a financial services provider that offers forex and CFD assets for trading over the internet. The brand is owned and operated by ‘R1Investing,; which is a Cyprus Investment firm that is authorized and regulated by the Cyprus Securities and Exchange Commission (CySEC).
Below is an example of short selling a CFD with r1investing. Below you can see what steps need to be followed in order to open position with r1investing.
- Click on ‘open account’ and fill the online form to create a new account.
- Verify the new account and make a deposit.
- When the account is approved, download the MT4 trading platform on a windows computer, an android or iOS mobile device.
- Open the MT4 application and login with your id and password.
- Locate the asset of your choice from the ‘Market watch’ window if using a computer or ‘quotes’ tab if using a mobile app.
- Double click on it and select ‘New order’.
- From the order window, select the trade volume, (stop loss and take profit values can be used if you wish).
- Click ‘sell’ to initiate the ‘sell’ order.
- Monitor the trade and close it when you are satisfied with the result.
1. High risk to reward ratio
Short selling could be rewarding if the trader’s forecast and timing is correct. Shorting CFDs in bearish markets can be profitable if the trader, shorts large volumes and predicts correctlywhen to enter and exit his trade positions.
Suppose a CFD trader has initiated a ‘buy’ trade for an asset but he knows that he is risking much and wants to curb his losses in case the trade goes against him. He can decide to hedge his position by short trading the same asset. Hedging is a risk management strategy used to reduce potential losses by taking a counter position to the traded asset. Many traders hedge their buy positions by shorting the same assets.
3. Low initial startup
Shorting a stock is not capital intensive since it is normally borrowed from the broker, sold and then bought back. Though most stock brokers require a minimum amount before traders can short trade. The short seller requires virtually no capital to commence short trading especially if borrowing from other sources. For CFDs, the financial service provider decides the minimum deposit required to open the leveraged account. It varies among providers.
1. High Risk investment
Selling short could be very risky because the financial markets are not predictable. If the trader’s analysis was wrong and the prices go up instead, he suffers a loss which could be over 100% of the original investment. In fact, the losses are not limited as the price could soar very high.
2. For experienced traders
Short selling (especially for stocks) is not suitable for newbies as it is very technical. Timing is of great essence. The trader must know the right time to enter and exit the market in order to try and maximize profits.
Short selling enables traders to take advantage of declining stocks, CFDs or other financial securities. It may be ideal for short term investments especially in the stock market where the shares are borrowed, sold and bought again at a lower price. Short trading may be good for hedging and it can result in potential profits when timed accurately. But, it is very risky especially if the prices go up instead of declining and will result in losses. So, it best practiced by veteran traders who can analyze, forecast and time the markets properly.
r1investing is a CySEC regulated financial services provider that offers numerous forex and CFD assets for trading on the MT4 trading platform. The platform is available on Windows PC, web browser and mobile apps for iOS and Android devices. It gives traders the necessary tools for trading and analysis. The brand offers low spreads and ultra fast executions within fractions of seconds. Newbies are provided comprehensive training resources in form of articles, videos and eBooks.
How do short sellers make money?
They make money when they buy back the borrowed stocks at prices lower than they earlier sold. For CFD traders, they profit from the price difference or spread. By selling high and closing out low, the price difference multiplied by the trade volume becomes the trader’s gross profit. However can result in losses when the prediction is wrong.
Is there a fee for shorting a stock?
Yes, upon returning the borrowed stock, the trader pays the broker some fees as well as any dividend received. For CFDs, most financial service providers mark up the bid-ask spread thereby incorporating their trading fees. Others charge a commission per trade.
Who loses in short selling?
When the short seller buys back the stock at a profit, the loser is the person that bought the stock at higher prices and sold at lower prices. For CFDs, the loser is the market maker which may be the financial services provider or any counterparty used by the provider. The investor/client can also suffer losses if the trades go against his position.
Is short selling illegal?
In most stock exchanges, it is not illegal. However, naked short selling has been proscribed in many exchanges. Naked short traders sell stocks and other securities without first borrowing them. For CFDs, shorting a position is completely legal and allowed by all financial services providers.
How long can you short trade?
There is no fixed time for shorting any financial asset. For stocks, it requires understanding with the trader and his broker. For CFDs, you can maintain a short position for months or years as long as the required margin is maintained.
The information above is for education purposes only and cannot be considered as investment advice and past performance is not a reliable indicator of future results