What Is Short Selling and How Does It Work?

The financial experts at Rockfort Markets explain all you need to know about short selling and whether or not it could be right for you.

Short selling is a trading terminology often used among traders. It is the concept of making profits from falling or bearish markets. Some refer to short selling as an advanced trading strategy. However, the term finds its traces in the stock markets.

As you may have heard, short selling is often frowned upon in the stock markets. The general rule of thumb, or an acceptable practice, is to buy and hold. Short selling is often seen as being detrimental to the markets.

After all, think about it. If you are short-selling a stock, you’re essentially betting that the company’s share price will fall, or in other words, betting that a company will fail. Going by this simple explanation, one can fathom why short selling is considered to be ‘advanced trading’ or just bad practice.

This is true depending on the markets in question. Quite often, the term short selling or sell short is used interchangeably across different markets. Therefore, the context here plays a crucial role. For example, in the derivative markets, where short selling is more prevalent, it can be done easily.

However, when it comes to the underlying cash markets, such as the stock itself, short selling is not that easy, for both regulatory purposes and also due to its difficulty.

In this article, we will explain what is short selling and also explain the appropriateness in different markets. It is also important to note some peculiarities with short selling depending on the market in question.

For the context of this article, we will focus on derivatives such as CFD which is the common type of financial instrument used by retail traders.

How does short selling work?

Before we go into the details, let us make clear on the definitions.

Going long is the term used when buying security or an asset. The term buy is more common in stock market lingo. However, in the derivatives world, going long is the equivalent of buying the derivative.

Going short is the opposite of going long. In other words, you are shorting the security. It is not the same as ‘selling’ in stock market lingo. In traditional investing, you only have two options. Either to buy a security or to sell a security that you bought.

Going short, or short selling is traditionally inferred to ‘borrowing a security’ (most likely from your broker) in order to short it. Once your trade is realised, you cover your short, or buy back the security at the prevailing price and return it to your broker.

This is the true essence of going short or selling short.

As you can see, selling and selling short are different. For the rest of this article, we refer to selling shorts as short covering. Perhaps the best way to understand short selling is by means of an example, using stock and using a derivative.

Example of short selling – How it works

Let’s say your retail broker allows you to trade stocks. The broker owns the security and you can buy it from them at the ask.

When you place such a transaction, you are purely buying the security from the broker at the market price. We will also ignore the concept of pending or limited orders and assume that transactions are taking place at market price, to keep it simple.

Therefore, if you wanted to purchase ten shares of TSLA, currently trading at $500, you would pay the broker $5000 and own the shares. After the price appreciates for a while, you want to close out this trade, and you sell at the market price of $600.

Hence, you are merely selling the security back to the broker.

Now let’s consider short selling.

Let’s say you expect the price of Tesla, which is trading at $600 currently, to fall to $400. But if you remember, you sold your shares at $600. So the question arises, how can you profit from this potential falling market for the stock?

This is where short selling comes into the picture. Under this practice, you ‘borrow’ the stock from your broker for the purpose of shorting it. Therefore, you borrow ten shares of TSLA at $600. When price indeed falls to $400, you will close this short trade.

This gives you a profit of $2000. After you close the short trade, also known as short covering, you then give back the shares to your broker. In return for this ‘favour’, your broker will charge you an extra financing fee for the duration of the trade.

Thus, what you just did by means of short selling is to profit from a falling stock price, without even owning the share.

Short selling in derivatives

When it comes to the derivative markets, short selling works differently. This should be obvious by the term, derivatives. As you may know, derivatives are purely synthetic instruments, used for hedging or speculative reasons.

As a result, you don’t own the underlying asset, but the derivative tracks the underlying asset prices. Therefore, in derivatives, you can take a long position or a short position. Examples of derivative instruments include exchange-traded derivatives such as futures and OTC derivatives such as CFDs.

When you trade forex, you are trading the OTC CFD markets, which can span across currencies, commodities, stocks and indices. With the derivatives instruments, you don’t have to borrow any asset, because there is no underlying asset for the derivative.

Thus, if you feel that the market will fall, you can straightaway open a short position and close this short position when your trade is realised. Therefore, you can easily buy and sell any derivative without any additional requirements or procedures.

It is also this ease of use that makes derivatives the preferred choice for speculative trading for many traders. To further illustrate this point, let’s look at how to can go short in the forex (CFD) markets.

How to go short in forex markets

The concept of short selling or shorting in the forex markets works exactly the same way as described in the previous section.

A unique aspect of the forex markets is that they trade in pairs. Therefore, even if you were long on EURUSD, you are in effect buying the EUR and selling the USD. Likewise, if you were short on EURUSD, you are selling the EUR and buying the USD.

However, the technical term to describe this is by saying that you are either long on EURUSD, meaning that you are bullish on the euro, or you are short EURUSD, meaning that you are bearish on the euro.

Since currencies are traded as pairs, it is easy to trade and profit from both rising and falling markets. However, this is not the case with stocks, in particular for reasons outlined earlier in this article.

Also, if you were to actually trade currencies, then once again short selling (selling the currency without owning it) can become complicated, and risky as well.

What are the risks of short selling?

Short selling is just as risky as going long or buying an asset. However, the risks associated with short selling a bit more expansive. For one, when you are trading forex, you are trading on leverage. Therefore, you are not actually putting up the full value of the contract you trade, but trading on margin.

This is known as leverage and as you may know, trading on leverage is risky. Therefore, if you use large leverage of 1:100, then you need to be very careful and pay extra attention to your position management. At the same time, if you want to trade on lower leverage, then you need a large capital.

Traders tend to find a trade-off between what leverage to use and the trading capital that they have.

The same concept holds true when trading stock CFDs too. Once again, these are derivative instruments, hence you don’t actually own the underlying asset. Therefore, it is easy to go short on the CFD contract without much ado.

Real risks of losing money

The real risk of short selling arises when you are truly short selling.

This means, borrowing the underlying asset for the purpose of profiting from a falling market. Due to the risks involved, the US Securities and Exchange Commission (SEC) has rules in place to regulate short selling.

Considering that the majority of the audience for this article are retail forex traders, we will not go into further details pertaining to the SEC’s short-selling regulations.

One of the biggest risks of short selling in the true sense is that no matter what happens, you have to cover your short to return the security to your broker. Therefore, if you short-sold security in hopes of profiting from a falling market, but the security moved higher, you are at a loss.

Let’s say you borrowed stock at $50, aiming to profit from a $10 decline. But instead, the price now rose to $60, putting you at risk of a margin call. In such circumstances, you would be forced to sell the security at $60 to your broker, incurring a $10 loss on your end.

The short squeeze

The short squeeze is another term you may come across frequently. A short squeeze is basically a market imbalance; too much demand, too little supply.

A short squeeze can be seen during market bottoms. As new traders enter the market in a bid to sell, they are often too late into the trend. As a result, they are very susceptible to any upside move in the market.

This can potentially mean that even a small move to the upside can weaken the new short sellers often forcing them to cover their shorts. The act of covering the shorts is nothing but buying back the asset. As more such transactions increase, there is actual demand for the stock, pushing prices higher.

Short selling – Conclusion

In conclusion, short selling is the technical term used more to describe the act of borrowing security with the intention to short it. In doing so, the speculator is merely profiting from falling markets for the security in question.

When it comes to derivatives trading, such as CFD, short selling is not the right word to use since you do not borrow the asset in the first place. Due to the derivative nature of CFD, you can go long or short without the act of borrowing the security.

This is perhaps one of the reasons why many traders prefer CFDs to trade the actual underlying markets, especially if one is a short-term trader. While the general rule of thumb for stocks is that there is large upside potential, with the forex markets, it is different.

Consequently, the risk of losing money in forex, in either direction is greater compared to trading stocks, where there is a positive to the upside.

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Offering dedicated account managers and an expert support team, Rockfort Markets is a registered Financial Service Provider and holds a Derivative Issuer Licence issued by the Financial Markets Authority. It is also a member of Financial Services Complaints Limited. For more information on the services offered by Rockfort Markets, click here.

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