What is short selling and how does it work?
Going short or short selling makes it possible to speculate on a falling stock price. But what is short selling? And how does short selling work? In this article we explain shorting a stock in simple terms.
What is short selling?
When you short sell a stock, you earn money when the price decreases. On the other hand, you lose money when the price of the stock increases.
You can go short on almost anything. It is possible to short sell shares, commodities, currencies and even cryptocurrencies. Especially in economically bad times short selling can be very profitable.
How can you short a stock?
Do you want to speculate on a declining stock price? By shorting a stock you can benefit from downward movements. In this section you can discover how you can short sell a stock yourself.
Method 1: CFD’s or contract for difference
The first way you can go short is by using a CFD or contract for difference. With CFD’s you can speculate on a fall in the price of a stock. You never become the owner of the product in which you invest. With CFD’s, you only trade in price differences of the underlying effect. The result is then credited to your account. Do you want to know more about CFD’s? Click here to read more about CFD’s.
There are several online brokers that offer the option to short sell using CFD’s. A good party that offers short selling is eToro. With this broker you can trade all popular CFD shares. A big advantage of eToro is the fact that you can try the possibilities with a free, unlimited demo. This makes it possible to discover how shorting a stock works without any risk. Click the button below to create a free (demo) account:67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
Method 2: short selling with a put option
You can short a stock by using options. A put option allows you to sell a stock at the current price. When the price falls, you can buy the stock for a lower price. This makes it possible to make a profit on a decreasing stock price.
A put option is always valid for a limited time. You pay a so-called premium to buy a put option. When the price goes up, your loss never exceeds the premium. This makes options an attractive method to short a stock. Do you want to learn how options work? Click here for more information!
DEGIRO is a good party for buying and selling options. You can create an account with this party for free, by using the button below:
Short selling can be very beneficial. Below we discuss the biggest advantages of short selling.
Having the option to short stocks increases your flexibility. When you buy shares, you can only achieve a positive result in an increasing market. When you also have the possibility to short sell, you can also benefit in decreasing markets.
Lowering risks by hedging
You can also hedge by shorting stocks. By hedging you can cover certain risks. Do you believe that stock prices will go down? Then it can be pricey to sell all your shares and buy them again later. You can cover your risks by taking on a short position on an ETF that tracks an entire market.
When investors panic, stock prices can drop rapidly. By short selling you can achieve a substantial return in a short time. Below, for example, you can see Shell’s price movements during the corona crisis in 2020:
There are also some disadvantages to short selling. Below we discuss the possible risks of short selling.
When you buy a share, you cannot lose more money than the value of the share. When a share costs $10, you cannot lose more than $10. With a short position, every increase costs you money. The value of the share could theoretically increase to $100 or maybe even $1000. Your potential loss is therefore unlimited.
When you short sell a stock, you have to pay the dividends. Fortunately, this is not a big problem: the price of a share drops as much as the value of the dividend that needs to be paid. On balance, therefore, nothing changes.
A big risk of short selling is a short squeeze. A short squeeze is a situation in which the price of a share increases considerably because there are many open short orders. When the price increases, the stop losses of many of those short positions will be hit. The holders of those short positions are then obliged to buy the shares, which further increases the price.
Against the trend
In the long run stock markets increase in value. When you place a short order, you place an order against the general trend. It is therefore important to time your short position well.
With many financial products you pay financing costs for your short position. For example, with CFD’s you pay a daily premium. When you open a short position by using options, you do not pay any financing costs. However, with options you do run the risk that your option will become completely worthless at the moment of expiry.
Short selling literally means selling shares you don’t own. I totally understand that this sounds confusing. That is why we take a closer look at how short selling actually works. I’m just warning you: the underlying theory is not simple and quite abstract! If you have any questions, feel free to ask them at the bottom of the article.
A simple explanation of how going short works
You sell stocks you don’t actually have
When you short sell a stock, you are selling shares you don’t own. In order to be able to sell these stocks, you will have to borrow them. These stocks are usually borrowed from a party that owns many stocks for the longer term. You can think of a bank, insurance company or a pension fund.
The investor is then obliged to cover the underlying value of the stocks. That way, the stocks can be bought back at any time. The lending party wants the guarantee that the investor can pay for the borrowed stocks when necessary. You should therefore always have enough money in your investment account. If you do not have enough money on your account, you can face a margin call. With a margin call, you can lose the entire balance on your trading account.
When the price subsequently falls, the investor can buy the stocks at the lower price and return them to the party who lent the stocks. This makes it possible to earn a profit with a falling stock price. The difference between the current price and the moment when the stocks are bought back determines the result.
The lending party receives a percentage of the value of the share. We also call this percentage the financing costs. You still have to deduct the financing costs from your profit. The amount differs per stock.
Fortunately, the bank or broker takes care of this complicated process. For us, as individuals, short selling is often a matter of pressing a button. The results are then automatically updated on your account!
A more extensive explanation of how short selling works
Short selling a stock can be done using user-friendly software. Most online brokers allow you to go short at the touch of a button. The software neatly keeps track of whether you make a profit or loss on your position. A good broker to short sell CFD stocks is eToro. With the user-friendly software you can choose within seconds whether you want to buy or short a security.
When you buy a security you speculate on a price rise and when you short a security you speculate on a price decrease. The biggest advantage of short selling is that you can always respond effectively to the market situation. Do you also want to take a short position? Use the button below to open a free demo account:67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
Short selling stocks can be very profitable. Stock market declines are often more extreme than rises, allowing you to make more money on a decline than on a rise. In addition, falls are often easy to predict: in the event of negative news, the prices often drop massively for a whole day, and you can take advantage of this!
You can achieve positive results within the eToro software by short selling. For example, it is possible to short sell all popular CFD shares within the eToro software. Negative news will drop the price, while positive news will push the price up. The great thing about eToro’s software is that you can try trading for free by using a demo account. Let’s take a look at how short selling works in practice.
You can choose to go short on a stock. This can be attractive in bearish markets. For example, the corona crisis resulted in significant falls on the stock market. The tens of percentages in loss can result in tens of percentages in profit for the short seller.
If you are the person who doesn’t get scared of a little tension, then it might be interesting for you to short sell the bitcoin. The volatile currency has collapsed several times. Negative news can cause the price of a bitcoin to collapse thousands of dollars. You can take advantage of this by placing short orders.
Going short on Bitcoin can turn out very well
There are three strategies investors use with short selling.
Speculate on the price
Day traders constantly try to take advantage of small price movements up and down. By short selling you can also achieve a positive result when the price drops.
Do you think that the prices of your stocks will drop significantly? Then you can cover this risk by going short by using a put option. You pay a small premium for this. Are the prices falling? Then you won’t lose any money. Are the rates rising? Then you will only lose your premium.
Some shares are traded on different exchanges. For example, Unilever shares are listed on the Dutch and English stock exchanges. Sometimes there is a tiny difference in the price of a stock between both exchanges. A positive result can be achieved if you go short on the share with the price that is too high. As a private investor, this way of investing is not possible, because you need fast computers to do this.
You pay transaction costs over your short position. The amount of the transaction costs depends on the broker. Most brokers calculate a spread. This is the difference between the buy and sell price.
You also pay financing costs over your short position. This is a daily fee over the total amount of your investment.
Timing is important when investing. But when is the best time to apply a short selling strategy? We discuss three moments when going short can be an attractive option.
Short selling during an economic crisis
Placing a short order can turn out well during an economic crisis. When traders panic, stock prices often drop sharply. By taking a short position, you are one of the few investors to take advantage of the situation.
Shorting after the release of bad business results
The publication of bad business figures can also be a good time to place a short order. Investors expect a certain profit. When the company achieved significantly worse results, the stock price can drop sharply. This might be a good moment to open a short position on the stock.
Go short on bad news
Bad news is also a good reason to go short. For example, the emission scandals caused the stock prices of various car manufacturers to fall sharply. As a smart investor you can profit from this!
The emissions’ scandal caused the price of Volkswagen to fall sharply between 2015 and 2016
It is important to be careful when short selling. The loss in a normal investment is limited to the value of the share. When a share costs $100 at the time of purchase, you can never lose more than $100. However, the potential loss on a short position is unlimited. The price of a share can theoretically continue to rise indefinitely.
Negative balance in short selling
Fortunately, most online brokers offer negative balance protection. This is the case with both Plus500 and eToro. This means that you can’t lose more than your investment. Still, you have to be careful with a short position. If you make the wrong decision, you can lose all the money on your investment account in one go.
What is a short squeeze?
When a stock rises sharply, a short squeeze can take place. The parties that went short suddenly have to deliver their shares. As a result, even more shares are bought, which further increases the price of the stock. Short positions can therefore contribute to an increasing stock price.
As a shorter, you are dependent on the willingness of other parties to lend shares. When large parties all decide to stop stock lending, it becomes impossible to go short. Fortunately, as a private investor, you usually don’t suffer from this. When this happens, the burden is often carried by the online broker.
With a simple example we will show how short selling takes place in practice. Imagine that a share is available for $100. You decide to take a short position on this stock with a CFD. After you open the position the price of the stock decreases with $10. You decide to close the position. You then make a profit of $10 per share.
By applying leverage, you can increase your result with a smaller amount. If you applied a leverage of one to ten in the above example, you would make a profit of $100 with the same investment. Do you want to know more about applying leverage to your investment? In this article you learn how leverage works!
What is naked short-selling?
Naked short-selling is entering into a short position without being able to deliver the underlying shares. This is not possible with most brokers. In any case, you will have to cover part of the position with money.
Short selling is considered a bad thing by some authorities. Companies that are already under pressure because of disappointing results can get into further trouble because of people who decide to short their stocks. For example, a massive number of customers of a bank can withdraw their balances from their bank accounts when they see that the stock price continues to fall further. As a result, the bank may eventually go bankrupt.
However, the possibility to short sell a stock is usually not the primary reason for a decreasing stock price. Short selling is strictly controlled by most governments. When the stock markets crash, it is often temporarily prohibited to place new short orders.
In the Netherlands, for example, the option to go short in SNS, AEGON and BinckBank was temporarily prohibited to give the stock exchange time to recover. In addition, the ability to short sell stocks can contributes to price formation of securities and can promote liquidity in the market.
Shorting can also keep companies straight. When something is not right, companies are severely punished for this. For example, the Luckin Coffee stock fell sharply after it was leaked that the company had committed fraud with its accounts. A company that shorted their stocks discovered the fraud.