What is Short Selling?
Short selling is a term that originated from the traditional stock market, and at its most basic level, it means speculating that the price of a stock will go down. The start was rather simple: a person loaned stocks from his broker in order to sell them. The hope was that the stock would plummet in value and he would be able to buy them back at a cheaper price and return the borrowed stock to the broker. The profits would be the difference between the earnings of the short sale and the cost of buying back the stock.
Short selling has always had many controversies surrounding it, but it still remains to date as market participants appreciate the vital role it serves. In fact, short selling led to the words ‘going short’, or just ‘shorting’; to remain engraved in trading lingo as the definition of selling any financial asset. Respectively, buying a financial asset is called ‘going long’, or just ‘Long’.
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How Short Selling Works
As indicated above, selling short involves 3 key steps:
- Borrow shares from your broker. Your broker can always loan out shares, usually owned by large institutions, to you. You will pay a small fee just like you would do when you borrowed any other asset.
- Sell the shares at the prevailing market price. You are seeking to short a trade because you anticipate falling prices and you believe the stock is overpriced. So, you will sell immediately at the market price.
- Buy back the shares. You will buy back the shares, hopefully at a lower price, so as to return them to your lender.
Here is a hypothetical short selling example:
Let’s say Apple stock is trading at £100 per share and you wish to place a short sale on it. If you decide to short 100 shares, your short seller’s account will have £10,000. If the price declines to £80 and you decide to cover your position, you will buy back the borrowed 100 shares, which will now cost you £8,000. Your profit will now be £2,000 (£10,000 – £8,000).
Why is Short Selling Controversial?
Short selling always sparks controversy when it is discussed. But the issue is usually moral in nature because short selling involves somehow betting that a company will do badly. When you short a stock, you are also a threat to the company’s shareholders whose wealth depreciates when your prediction is right. But financial markets are cyclical in nature, and short selling offers active traders the chance to make money when markets are also falling. Still, critics maintain that sometimes, aggressive short selling has the potential of turning normal corrections into full blown bear markets.
There are some restrictions on many exchanges regarding short selling, particularly naked short selling. While normal short trading involves selling actual borrowed shares, naked short selling involves selling shares that you do not own, have not borrowed, nor positively determined that they truly exist. This is inherently risky as it leads to market distortion and in the worst-case scenario, it can be the genesis of an economic recession.
Why is Short Selling Important in Financial Markets?
Short selling is more than a necessary evil. It makes markets become more transparent and efficient. The incentive to short sell allows for the truer pricing of financial assets. If there was no short selling, there would be numerous fake-priced assets that can even expose a market to greater risks, such as a bubble.
Short selling also offers the incentive for market participants to perform in depth analyses on their favourite assets. Short sellers have always been responsible for uncovering unethical or fraudulent activities of major businesses.
When Should You Short Sell?
The ability to short sell offers traders plenty of possibilities. Here are some of the times that UK traders can consider short selling:
Short selling allows traders to hedge their positions in the market, effectively minimising their overall risk exposure. For instance, let’s say you are optimistic about the long-term prospects of the UK banking industry and decide to buy Barclays Bank shares. If any short-term concerns arise, you can decide to hedge your position by short selling Standard Bank shares. If the banking industry experiences any decline, your profits from the short sell can limit the overall hit you take on your Barclays Bank shares.
- Bear Market
Financial markets are cyclical in nature; there are phases of boom and bust. When markets are in turmoil, such as in an economic recession, stock prices usually drift lower. This offers short sellers a unique opportunity of making profits in a bear market.
- Negative News
When there is bad news for a specific stock or industry, the underlying stock prices will always react negatively. For instance, privacy breach headlines can impact the stock prices of the technology companies that are involved. As well, a company that announces a negative profit alert or releases earnings that fail to meet investor expectations, can trigger losses to its stock price. Short sellers can take advantage of bad news to make money out of a company that is performing poorly.
Advantages of Short Selling
Here are some of the many advantages of short selling:
- Short selling gives UK traders access to financial assets that they would otherwise not be able to trade. You do not have to own the underlying financial asset, but you can profit from its declining value.
- When using short selling for hedging purposes, UK traders can keep their long positions running without incurring the capital gains tax they may attract if they decide to sell.
- Short selling reduces the risk a trader takes. You make money out of the price movement of the underlying asset, without out owning it. For instance, if you bought physical gold and prices plunge, you will remain with a less worthy commodity and may even lack interested buyers.
- Short selling is almost always done on margin. This means that traders only deposit a small amount to cover a much larger sale. This means that any successful trade will result in massive returns.
- Short selling provides just about the only way to make money in falling markets or during economic recession.
- Usually, markets fall harder than they rise. This means that short selling opportunities can deliver massive gains for UK traders.
The Risks of Short Selling
Here are some of the risks that traders should be aware of when short selling:
- The major risk for short selling is increasing share prices. When buying a stock, the greatest risk is that the stock price will fall to zero (usually unlikely); but the upward potential is unlimited. On the other hand, when shorting a stock, your profit potential is limited, but you face unlimited loss potential. There is no limit as to where a stock price will rise, but there is a limit of how low it can fall (zero). To mitigate this risk, traders should always monitor their short positions and seek to cover them as appropriately as possible.
- If you short sell a stock and maintain the position when the underlying company declares dividend, you will have to pay your lender the equivalent amount of the dividend payout. This can impact on your returns, or even turn an otherwise profitable trade into a losing one.
- Short Squeeze – A short squeeze occurs when a stock does not tumble as initially expected. Markets are always driven by forces of demand and supply, and when a short squeeze occurs, panic will kick in among short sellers. They will begin buying back their stock to cover their positions. As more and more short sellers join in on the frenzy, massive buying pressure will be generated that will drive up stock prices. This will effectively mean losses for many short sellers.
- The long-term trend of the stock market is up. This makes short selling a contrarian strategy that can only be successful with good market timing.
- There is also the ‘buy in’ risk. A ‘buy in’ occurs when a broker closes short positions because lenders are demanding their shares back. This usually happens when a stock is heavily shorted. This unpredictability can lead to sudden and unanticipated losses for short sellers.
- Trading off bad news is a key strategy for many short sellers. But this is also inherently risky because markets may have priced in the data already. So, you may decide to short a stock on the back of bad news but end up losing anyway because the market has already factored in the data in the current market price.
Short Selling with AvaTrade
If you can buy a stock, you can sell it as well. If you can pick a ‘winning’ stock, you can also pick a ‘losing’ one. Short selling ensures traders can make money independent of price direction. As a widely accepted trading method, short selling can be applied across all types of tradable financial assets.
At AvaTrade UK, traders can apply short selling on currency pairs, commodities, stocks, indices and even on cryptocurrencies. Other advantages of short selling with AvaTrade include:
- Guaranteed Stops
Guaranteed stops work the same way as standard stops but will always be triggered at the exact price point that you set, regardless of whether price gaps or slippage occurred. This is very important when short selling because it means that you will always be protected if a trade moves in the opposite direction.
- Negative Balance Protection
Short selling might carry unlimited risk, but AvaTrade UK traders cannot lose more than their total equity. They will also not be required or forced to fund their trading account to cover losses. AvaTrade has assured a no strings attached negative balance protection.
- Well-established Trading Analysis
Short selling requires near perfect market timing so as to pick out low risk, high reward opportunities in the market. AvaTrade helps out in this regard by delivering high quality daily expert analysis on major assets to help you determine where to go long and where to go short. Aside from that, there are plenty of other educational resources that will help continue to sharpen your trading skills, so you can identify high probability short selling opportunities yourself.
- Seamless Trading
As indicated earlier, effective short selling requires good market timing and effective trade monitoring. This is made all the more easier by AvaTrade UK, which allows for seamless trading across all its platforms. AvaTrade use the popular and advanced MetaTrader 4 (MT4) trading short selling platform, which has seamless functionality across desktop and mobile devices.
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