A Simple Guide To Short Selling
If you want to speculate on the financial markets you have to have a good grasp of what short selling is and how it can make/lose money. Speculating without at least having the advantage to short sell the market is akin to playing golf with one arm.
One important point to note is that the principles of short selling work exactly the same if shorting an individual shares like Vodafone, a stockmarket index like the FTSE 100, the Dollar/Euro exchange rate or Gold - basically any financial instrument.
This guide offers a simple introduction to short selling.
An Introduction to Short Selling
Too many people get confused with short selling because they try and understand everything at once. Sometimes the actual mechanics and paperwork behind short selling can be complicated. But if you really want to understand this concept you have to break it down piece by piece.
- Short selling is a concept of trading that allows investors to profit from a fall in a price of an instrument rather than a rise
- Traditional investing or speculation has always been about rising markets
- An investor buys ABC stock at £1.00 per share and then sells it in the future at £1.25 turning in a £0.25 profit per share
- Short selling is the opposite - A trader has NO holding in a stock and becomes bearish on his outlook on the ABC company expecting its price to decline -
- The trader sells the share at £1.00 to go what is effectively know as 'short'
- The ABC shares do decline and he then buys or 'covers' the short position at £0.70 making a profit of £0.30 per share
- It is critical NOT to get sidelined by the fact that 'how can you sell something you don't own'
- Just concentrate on the mathematics of what is involved and how a profit or loss is generated
Short Selling Is The Reverse Process Of Buying A Share
- If we are bearish on a stock we expect prices to fall
- Therefore the exact opposite trade mechanism is required to make money than if a stock’s price was expected to rise
- When we expect price rises we buy the share first and then sell it at a higher price
- When we expect a share to go lower we SELL the stock first (without owning it in the first place) and then BUY it back at a LOWER price
The Maths - A Winning Short trade
- Sell stock short at £5.00
- Stock price FALLS
- Buy stock at £4.00
- Profit = £1.00 per share
A Losing Short trade
- Sell stock short at £5.00
- Stock RISES
- Buy back short stock at £5.75
- Loss of £0.75 per share
P & L Profile of a short trade
Use Cricket To Understand Short Selling
You are watching a cricket match. Your friend states that he fancies his team (Essex) to score at least 400 runs. You disagree and so decide to have a bet.
- You wager £20 on the fact that Essex will not make 400 runs, therefore if the team scores under 400 you will win. If the team scores over 400 you will lose
- The opposite is true for your friend’s bet. He will win £20 if Essex scores over 400 and will lose the bet if they score under 400
- Your bet is effectively a short trade. Your friend's bet is effectively a long trade
- You have in effect sold runs short at 400 and he has bought runs at over 400
Let's Expand The Bet
We know in the markets that trades are not actually put on for fixed money (£20 win/lose). So let's look at this example in more detail -
- You again decide to bet but this time the wager is £1 per run instead of a flat £20
- That means that for every run that the team scores under 400 you will make £1 x the number
- Conversely, for every run that is scored over 400 you will lose £1 x number of runs
- You have shorted runs at 400
- Your friend has done the opposite. For every run that the team scores above 400 he will make £1 x the number
- For every run that is scored under 400 he will lose £1 x the number
- Your friend has bought (gone long) runs at 400
The Short Sale in Cricket - Three possible outcomes
What are the possible results of your short trade -
1. Winning trade
- The Final score is 325 runs
- 400 (the level at which you went short) - 325 (final score) = 75 runs
- 75 runs x £1 (per run) = £75 profit
- Remember you bet that the team would make a score under 400, so you would make £1 profit on every run under this level
2. Losing Trade
- The final score is 450 runs
- 400 (the level at which you went short) - 450 (final score) = -50 runs
- -50 runs x £1 (per run) = -£50 loss
- You bet that the team would score under 400, therefore you would lose £1 per run on anything over this amount
3. Breakeven Trade
- Final score is 400 runs
- 400 (the level at which you went short) – 400 (final score) = 0 runs
- 0 x £1 = no profit/loss
A Spread Betting Example - FTSE 100
The FTSE 100 spread bet market is priced at 6100 - 6104 (bid/offer spread). You are bearish and expect prices to decline. You therefore sell short the market at 6100 risking £1 a point. Profits will be made is the FTSE 100 declines and losses if the market rises.
Three Possible results for this short trade -
1. Winning Trade - FTSE futures drop to 5910
- What is your profit?
- 6100 - 5910 = 190 points
- £1 (price per point) x 190 points = Profit of £190
2. Losing Trade - FTSE futures rise to 6175
- What is your loss?
- 6100-6175 = -75 points
- £1 (price per point) x -75 points = £75 loss
3. Breakeven trade - FTSE at exactly 6100
- 6100 - 6100 = 0 points
- £1 stake x 0 points = zero
Short Selling Summary
Short selling is a relatively simple concept once you understand how it is done. It is also an important part of any trader's toolbox for it means that they can not only profit from bearish moves in stocks, options or indexes but can also use some of these instruments to effectively hedge or take protection over investments that will suffer in declining markets.
One area where traders new to these concepts always seem to get bogged down, is in the theory behind the process. The question of how do I sell stock that I don’t own is often asked? Again leave the market mechanics to the brokers, they have extremely sophisticated back offices and processes that deal with these issues, the important points for the traders to understand are simple - How do I make and lose money using these concepts.
Tip: One way of finding your feet with short selling is to practice on a demo account which many of the spread betting firms offer via their websites.
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