What is Short Selling?
Reading time: 23 minutes
What is Short Selling? Short selling explained
When markets are going up, the conventional wisdom of 'buy low and sell high' can work out very well. If you buy shares in Company 'ABC' at $100 and then sell it at $150, that's a tidy profit of $50, minus any commissions or interest. But, what happens when the market isn't going up? What happens if the market is going down? This is where short selling comes into play.
If you bought Company ABC and its value went down to $50, you would lose money when you sold. Short selling makes it possible to profit on the stock market regardless of if it is increasing or decreasing in value. As long as the market keeps going in your direction, your short position will be making you money.
In this article, you will learn everything you need to know about short selling. What does it mean to short a stock, how short selling works, why you should consider short selling via CFDs, how to short a stock CFD, the best stocks to short, and the markets you can trade short positions on!
What is Short Selling?
Short selling is taking a bearish, or negative, trade on an asset. Rather than buying low and selling high, you sell high and buy low, and make a profit on the change in the asset's price.
Let's continue with the previous short selling example of stocks in Company ABC. If you believed it was going to go down, instead of opening a 'buy' trade, you would open a 'sell' trade. You open the trade at $100 and the price of Company ABC falls to $50. You would then make a profit of $50 - the difference between the opening and closing price of the stock.
Before we look at some of the reasons why you would consider shorting a stock, or any other asset class, let's first understand how short selling works, and how you can make your first short trade.
How Does Short Selling Work?
One of the biggest questions new traders have when considering short selling is, how can you sell something you don't own?
For a traditional short sale, a trader would begin by borrowing the shares of a stock that they do not own (usually from their broker's account). They would then sell these shares on the open market at the lower market price.
The goal of the short seller is to later re-purchase those shares at a lower price, and return borrowed shares. They would then pocket the difference between the initial sale price of the stock and the cost of buying them back.
Mathematical Formula of a Short Sale
The mathematical formula of short selling is relatively simple. By default, online brokers always show net gains or losses on trading platforms.The lower the repurchase price of your shares relative to your selling price, the more money is earned. In other words, the lower the price of the stock sold short, the more likely you are to make significant gains.
The formula is:
(Sell Price - Purchase Price) x Number of assets - Transaction Cost = Profit
Here's the breakdown of each part of the formula
- Sell Price = Price at which the trader sells the financial securities
- Purchase price = Price at which the trader redeems the sold securities
- Number of assets = Number of assets sold by the trader
- Transaction cost = Broker's commission
If the result of this formula is:
- Positive: the trader realised a net gain
- Negative: the trader realised a net loss.
An Example Of Short Selling
Let's assume that a trader took a short position of 100 shares of Company ABC, at a price of $20 per share. After a period of time, the stock declines to $10, and the trader then decides to re-purchase the shares. The profit on the trade would be $1,000, minus any commissions and interest.
($20 - $10) x 100 = $1,000
However, what would happen if the stock went up after the trader took on their short position? Let's say that Company ABC spiked to $50 per share and the trader decided to cut their losses. In this case, their loss would be $3,000 [($50 - $10) x 100], on top of any commission and interest that they had to pay for the position.
As you can see here, the losses are greater than 100% of the invested capital, with the initial investment being $2,000 ($20 x 100 shares), and the loss being $3,000. This is the major risk of short selling - an infinite loss. Since there is no upper limit to a stocks' price, the short seller's maximum loss is theoretically infinite.
However, there are products available that can help short sellers to minimise risk. For example, did you know that it's possible to practice your short selling strategy, without putting any of your capital at risk? That's right. With an Admiral Markets risk-free demo trading account, professional traders can test their strategies and perfect them without risking their money.
Why Should You Consider Short Selling Via CFDs?
A CFD (or Contract for Difference), allows traders to speculate on the rise and fall of a market, without owning the underlying asset. Essentially, a CFD is a contract between two parties - the trader and the broker. At the end of the contract, the two parties exchange the difference between the price of the stock at the time they entered into the contract, and the price of the stock at the end.
Rather than having to invest in stocks traditionally, the trader is paying the difference between the opening and closing price of the stock, or instrument they are trading. The simplicity of entering and exiting positions, compared to other trading vehicles, is just one reason why short selling stock CFDs is very popular. That's not to say it's easy, of course, but there are some benefits, such as:
- Leverage - a retail trader can trade positions five times their balance. A professional trader can trade positions twenty times their balance.
- Trade in any direction - Go long or short on any stock. No extra charges on short sales.
- Advanced risk management tools - use stop loss orders and take profit levels to minimise risk.
- Access global stock markets - trade US Share CFDs, EU Share CFDs, UK Share CFDs
Having the right products at your fingertips is hugely important to traders involved in global markets. With Admiral Markets, there are several different options available when it comes to investing and trading with Stocks, ETFs, Share CFDs etc. For example, Admiral.Invest enables traders to buy and own stocks. Admiral.Markets, Admiral.Prime, and Admiral.MT5 enable professional traders to trade with currencies, cryptocurrency CFDs, Stock CFDs, Bond CFDs, and much more!
If you would like to explore each option in detail, make sure to read about Admiral Markets' account types, where you can explore a detailed breakdown of all the trading instruments available for each account, the leverage available, and more. Put simply, with an Admiral Markets CFD trading account, you can speculate on rising and falling prices. This offers traders unique flexibility when trading the financial markets.
Ready to make your first short trade? You can start trading today here.
How Do You Short a Stock CFD?
Thanks to virtual trading software, short selling a market has never been more simple. The key is in owning the right platform. For example, the MetaTrader Supreme Edition plugin for MetaTrader 5 enables you to trade across US, EU, and UK Share CFDs with advanced platform features.
Source: Admiral Markets MT5 Supreme Edition - #AAPL, Weekly Chart. Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
The chart above displays Apple stock. The MT5 Supreme Edition platform enables traders to view historical price data of stock prices, as well as the ability to use a whole range of free trading indicators, to aid with making trading decisions. This version also has the 'Mini Terminal' feature which allows you to choose the parameters of your trade.
To place a short order one would simply click the 'Sell' button, where you can also add a stop loss and a take profit level. These orders help traders to get out of their positions at predefined price levels, either at a loss or in profit.
How to Short Sell on MT5
- Create a demo or live trading account with Admiral Markets.
- Download and install MetaTrader 5 for free.
- Open MetaTrader 5 and sign in using your demo or live account details.
- In the 'Market Watch' window, double click the asset you would like to short sell.
- Add the volume and an optional stop loss and take profit, and then click 'Sell by Market',
Prefer trading in MetaTrader 4? Good news - the process is the same! If you're new to the MetaTrader trading platform, you can see how they work in this video:
How to Short a Stock in MetaTrader Supreme Edition
- Log in to your trading account
- In the 'Navigator' window, expand 'Expert Advisors' and select 'Admiral - Mini Terminal'.
- Drag 'Admiral - Mini Terminal' to the chart of the instrument you'd like to trade.
- Add the volume of your trade, and optional trailing stop, stop loss and take profit.
- Then click 'Sell'.
Source: AC CFD, Chart M5, MetaTrader 5 Supreme Edition Admiral Markets, November 26, 2018
Before trading, though, it could prove to be useful to have some idea of which stocks are suitable for shorting opportunities, so let's take a look:
When is the Best Time to Short?
Unfortunately, no one can predict the future. However, there are certain scenarios where short selling stocks may prove to be useful, here are three scenarios where short selling stocks might potentially be a good move:
#1. A financial crash happens
Remember the 2008 financial crash? What about the 2000 tech bubble? Crashes do happen, albeit not that often. However, it's all about being prepared, so if it does happen, you know what to do.
#2. A company scandal
This scenario happens more frequently than financial crashes. Remember Volkswagen's diesel emission scandal in 2015?
Source: Admiral Markets MT5 Supreme Edition - #VOW, Weekly Chart - Data range: April 1, 2011, to November 18, 2018 - Performed on November 18, 2018, at 9:52pm GMT - Please Note: Past performance does not indicate future results, nor is it a reliable indicator of future performance.
The box highlighted in yellow displays monthly bars of the drop in Volkswagen's stock price during the diesel emission scandal. The move down wiped out three years worth of rising prices. Having the right platform and product to be short the market could have proved useful in this particular instance, depending on your strategy.
#3. An earnings miss
Every quarter, public companies release their earnings report. Analysts give out their estimates on what they think the numbers of earnings per share and revenues, amongst others, will be. If the company misses these estimates, it causes some traders to dump their stock and some to initiate new short positions. After a series of bad earnings reports, the company could start to exhibit features of a down trend.
Source: Admiral Markets MT5 Supreme Edition - #AA, Daily Chart - Data range: June 27, 2017, to November 18, 2018 - Performed on November 18, 2018, at 10:02pm GMT - Please Note: Past performance does not indicate future results, nor is it a reliable indicator of future performance.
The screenshot above is a chart of Alcoa, the world's sixth largest producer of aluminium. After enjoying a rising price for much of 2017, mid 2018 marked the point where the stock started to fall. Having the flexibility to participate in the upside and downside puts traders in unique positions of market activity. Sometimes a trader wants to participate in shorting the market, rather than an individual stock. This is another benefit of short selling with CFDs.
What Markets can you Trade a Short Position On?
With Admiral Markets you can participate in short selling, or taking a bearish approach on multiple assets. So what other assets can you take a short position on? Here are some examples:
- Commodity CFDs
- Index CFDs
- Bond CFDs
- Share CFDs
The Most Popular US Stocks for Short Selling
Below is a list of the best-selling US stocks traded with Admiral Markets, during the month of September 2019:
- Disney: 47,44%
- Apple: 14,37%
- Netflix: 10,49%
- Facebook: 10,29%
- Tesla: 5,27%
- Alibaba: 4,06%
- Twitter: 2,81%
- Microsoft: 1,85%
- Amazon: 1,51%
- Deutsche Bank: 1,46%
The Short Squeeze: Another Short Selling Method
A squeeze on the stock market occurs when stock prices drop sharply and quickly following an adverse announcement. Graphically, it often occurs after the break down of a support or a reversal figure as a sell signal.
Savvy investors then take advantage of this decline by buying the stock at a lower price en masse.
The prices then rapidly bounce back, which traps traders with losses. This effect is exacerbated by the liquidity and the influx of purchase orders without selling traders, since everyone is looking to buy.
Volkswagen: The Biggest Squeeze Short of all Time
In 2008, the automobile sector suffered a large blow because of the indirect effects of the subprime crisis. Hedge funds and speculators were targeting downward-moving stocks in the sector, and Volkswagen was an ideal mark for this trend.
Source Admiral Markets MetaTrader 5 - Volkswagen, Weekly Chart - August 2008-January 2009
From October 17 to 24, 2008, Volkswagen shares dropped by more than 50%. Over the next two trading days (October 27 and 28, 2008), they suddenly rose from €200 to €1000, an exponential increase of over 400%!
This spectacular rebound is explained by the strengthening of Porsche within the capital of Volkswagen from 35 to 42.6%, and the holding of call options up to 31.5%. Thus, Porsche's participation amounted to 74.1%. The German regional state, Lower Saxony, preferring to keep its titles, remained at only 6% of the available float on the market.
When speculators heard this news and saw the bearish scenario turn to their disadvantage, they rushed to buy to limit their losses. But since there were so few shares on the market, this caused the biggest short squeeze in history.
Without neglecting the emotional impact on short sellers, this was a temporary phenomenon that lasted just a few days. Very often, it does not create a significant consequence on the underlying market trend.
In just a few clicks, you can start trading stocks with an Admiral Markets account! Click the banner below to get started.
Short Selling Strategies
Short trading strategies are by nature speculative in the short and medium term. The maximum profit available to short sellers is the equivalent of the price of the asset at the time the trade is opened.
In order to achieve this profit, it's important to follow a strategy. Below we'll share a short selling strategy for the DAX30 CFD, as well as how you can use technical analysis for successfully short selling stocks and other instruments.
Short Selling Strategy on the DAX30 CFD
Source: DAX30 CFD, Chart M5, MT5 Admiral Markets, November 26, 2018
The German index generally reacts favorably to the publication of the ZEW index. If the published value of the ZEW is lower than the value projected by market analysts, you can anticipate a decline in DAX30 prices and begin short trading.
Short Selling with Technical Analysis
One of the most common short selling strategies used in technical analysis is to open a trade after the confirmation of a bearish breakout on an uptrend line.
The second strategy of short selling is to identify a downward flip figure such as a shoulder-head shoulder, an ascending bevel or a double-top. To increase your chances of winning, you can combine bearish breakout on the bullish line with the flipping figure.
A third short selling strategy is to play price differentials with moving averages. For example, you use the 50- and 200-day moving averages (MM50 and MM200).
- If MM200> MM50, the bias is bearish, the MM200 plays the role of resistance. A short stance on the MM200 approach would be an opportunity to bet on a deeper decline in financial assets.
- If MM50> MM200, the bias is bullish, the MM200 plays the role of support. A short position at the break down of the MM50 would be an opportunity to target a goal on the MM200 without questioning the bullish bias.
How to Protect Yourself from Short Selling Risks
Short selling can be risky, but there are three simple ways to protect yourself against the potential setbacks:
- Put a Stop Loss on sell orders
- Use volatility protection tools
- Choose a broker with negative balance protection
Using a stop loss is the easiest way to protect yourself. It allows you to define in advance the maximum risk of losses that you can tolerate on your short position. It is a useful tool that should be used habitually, protecting also against the risks of slippage and stock market gaps.
You can see how to set a stop loss and take profit in MetaTrader 5 in the following video:
Another method to mitigate the risks of slippage and excessive volatility is to take advantage of the volatility protection tools that Admiral Markets offers. The most significant of these is the execution of stop and market orders as limit orders with predefined maximum slippage. This gives traders the possibility to to enter the market with a limited risk and potentially unlimited additional gains. Predefine the maximum acceptable slippage from 1 to 1000 points per account in the Account Settings page of the Admiral Markets Trader`s Room. When a stop order is triggered or a market order is requested, a limit order is placed instead at the price that is less favourable by a predefined amount of points. A limit order like this is placed under the terms when it is immediately triggered, so it can be only executed with positive or zero slippage or otherwise just cancelled. Therefore, the maximum slippage of the original stop or market order is limited to a predefined amount of points, while the positive slippage of the resulting limit order can be unlimited.
To further protect its customers, Admiral Markets also offers a Negative Balance Protection Policy. If your account somehow lands in the negative, it will be automatically reset to €0. You will not risk losing more than your initial capital. To learn more about Admiral Markets' negative balance protection policy, click the banner below!
Short Selling and Dividends
Sellers can not withdraw dividends on securities they hold positions on.
It's not exactly a risk, it's a logical consequence. During a stock short sale, the seller does not benefit from the distribution of dividends simply because they do not own the shares, they are being lent to their broker. Dividends are cashed by the lender, who is the true owner of the stock.
Why Short Selling Can be Restricted
It can happen that a certain market or regulatory body might halt the ability to short sell a given stock or stocks. Restrictions on short selling in general are made to protect companies and prevent abuses by unscrupulous speculators. There are many reasons why short selling can be restricted, but the primary reason it occurs is due to economic reasons and factors.
Restriction of Over-the-Counter Sales for Economic Reasons
When too many speculators simultaneously short a stock, a company's stock price may collapse. Investors seeking long-term investments may become suspicious of the stock, and may also decide to sell their stock, which accentuates the bearish spiral of the stock in question.
This snowball effect can collapse the stock market valuation of a company.
For the company concerned there are real interests at stake: it can be denied loans to finance its cashflow, its suppliers may deny it payment facilities for fear of not being paid.
The risk is that companies that are economically viable and that provide jobs will go bankrupt or experience great difficulty without any justification. It is only because their stock has attracted the attention of too many short sellers simultaneously.
Short Selling Protection Rules for Financial Authorities
In order to mitigate the risks that short selling imposes on companies, the financial market authorities have adopted strict rules.
The main protection against short selling speculators are the brokers and financial intermediaries who carry out the transaction between the trader, who borrow the securities, and the lender, who lends his securities to the trader. Regulators will require brokers to own a percentage of the loaned securities.
For example, if a trader wishes to sell 100 Total SA shares, the SEC may require the broker acting as an intermediary to hold at least 70% of the shares, (i.e. 70 Total SA shares).
The second rule of protection used by regulators is the obligation to publish short selling positions held in the portfolio. Once you sell more than a certain percentage of a company's shares, you must notify the regulator and make your position public. In France, the AMF sets this threshold at 0.5% of the capital of a company, while the US' SEC doesn't have any such restrictions.
How Short Selling Can Bring Balance to Stock Markets
There are a number of arguments in favour of short selling, when it comes to the health of the markets. These are:
- Short selling naturally regulates stock markets
- Short selling brings liquidity to financial markets
- Starters launching alerts to detect fraud
Proponents of short selling highlight its role as a natural market regulator. When markets experience long periods of uninterrupted rises, this leads to imbalances, and assets are artificially overvalued. Short selling is a natural way of reducing assets to their true value as speculators weigh down on the price of an asset.
The perfect illustration of this self-regulating mechanism is the will of the Chinese government to expand short selling in its market, where many stocks are overvalued because of a lack of transparency and communication. The overvaluation of companies is just as harmful for both itself and their shareholders in the long run as undervaluation.
Short selling also provides liquidity in naturally illiquid markets. Liquidity is essential to attract investors, it guarantees them to be able to resell their title at the desired moment. Historically, short selling is more effective than any tool available to regulators today to attract liquidity to a market.
Since short selling carries significant risks, traders use it only after a thorough analysis of a company. They do not just analyse the financial figures. After detecting anomalies in the conduct of a business or financial figures, the traders are positioned massively for sale. These financial positions push the regulators and public authorities to be interested in sellers but also in the company under attack. Thus, the existence of fraud with disastrous consequences in the long term can be updated and stopped thanks to the short sale.
One example of this occurring is Herbalife, a pharmaceutical company whose products contained up to 10 times the maximum permissible lead content, with serious health consequences for consumers. The authorities weren't interested in thoroughly investigating the company following complaints from consumers, but after several hedge funds got wind of the fact and pushed the value massively downward on the market, the authorities deepened their investigation and uncovered massive internal fraud.
Short Selling Explained: Conclusion
Short selling an asset means to take a bearish view on its price. In this instance, the trader believes that prices will fall. Maybe they are considering shorting the market because of a potential financial crash. Or, perhaps they are shorting stocks due to an earnings miss, or maybe it's a simple down trend scenario.
The traditional method of short selling stocks is to borrow the stock, and then sell it on the open market, buying it back when the prices fall. However, there are now simpler products, like Share CFDs, that allows traders to speculate on prices rising or falling without any ownership.
Platforms like MetaTrader 5 and add-ons like the MetaTrader 5 Supreme Edition plugin can help traders in their decision making process, by providing advanced trading features. In addition, with a demo trading account, you can practice taking a short position on multiple asset classes such as Share CFDs, Forex, Index CFDs, Commodity CFDs and Bond CFDs. If you are considering learning the art of short selling, trading in a risk-free environment can help you hone your trading skills, and inhibit you from putting your capital at risk, until you are ready to do so.
To get started with your trading experience, click the banner below and download MetaTrader 5 for FREE!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.