What Is Short Selling and How Does It Work?

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.