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What is Shorting in Trading

 

In 1987, Paul Tudor Jones made $100 million in a single day by taking massive short positions in the US markets right before 1987’s “Black Monday” crash.

Five years later, George Soros famously ‘broke the Bank of England’ by shorting the pound in the midst of a major currency markets attack. He became a billionaire virtually overnight.

John Paulson bet against the US housing markets in 2008 and made himself more than four billion dollars that year.

In fact, many of the most famous trades in market history were “Short” trades. But what is shorting in trading?

The first thing we’ll say is don’t be fooled by these ‘outlier’: shorting can be a dangerous way to trade. Shorting carries more risk than traditional trading, and can cause you to lose a lot of money in a very short amount of time.

But if you want to become a better, smarter trader, then you should at least understand what shorting is and how it works. That way, you can add it to your trading strategy if you think it’s right for you.

In our complete guide, we’re going to show you: 

  • What shorting is (with examples)
  • The 2 key potential benefits of shorting
  • The 4 key methods of shorting (with the benefits and downsides of each)
  • Which assets you can short, and which you can’t
  • The key risks and dangers all traders face when short-selling
  • 3 strategies for pinpointing potential short positions (and how do you tell if a stock is being shorted?)
  • Why shorting the markets could put you at odds with your fellow traders

And then, we’ll be showing you how you can practise placing a short trade today, without risking any money.

Ready? Let’s get started…

 

What is shorting in trading? (A simple explanation)

if you place a trade on a particular stock, you're doing so because you believe the value is going to go up.

If you're right, the difference between the price you bought at and the price you sold at is your profit.

When you 'short' a stock, you're doing the opposite. And again, if you're right, you will profit from the difference between the prices you bought and sold at.

In the most basic sense, the two approaches are the opposite of one another. (That’s why a normal trade is also known as a ‘long’ trade.)

 

Example: Let’s say that you believe Company A is struggling due to the recession. They have a shareholder’s meeting on Monday, and you believe they are going to announce major losses at that meeting.

So, on Friday, you place a ‘short trade’ on the company’s stock, which is currently valued at 10,000 points.

You place that trade at £2 per point. (This is known as ‘leveraging’ the position. More on this later, because it’s important.)

The board meeting goes ahead, and as expected, the company announces serious losses. The share price falls by 1,500 points.

You close your position. You were correct by £2 a point. At 1,500 points, this gives you a trading profit of £3,000.


As always, though, you must consider the risk. Had you shorted the company and then seen the stock rise by 1,500 points, you would have lost that £3,000.

 

What are the main short-selling benefits? (There are two main short-selling benefits)

 

What is Shorting in Trading

 

1. Short-selling gives you the opportunity to profit from falling market prices, if you’re correct.

As we’ve just shown you, shorting gives you the opportunity to profit from assets you have reason to believe are going to fall in value. If you’re correct.

This can be beneficial in times where equities are suffering across the board, and it becomes hard to find profitable long positions. 

During the Dot.com bubble in the early 00s, when tech stocks were almost all tumbling in price, Sir John Templeton reportedly shorted 84 Nasdaq tech stocks, and cashed in to great success.      
 

2. Short-selling can be an effective way to protect ‘long’ trades 

Some traders use short-selling as a way to protect their ‘long’ trades in the event they suffer loses. This is known as a ‘hedge’. 

Example. Let’s say you’ve decided to make a ‘long’ trade on Gold, because you believe the price is going to go up over the next month. 

To minimise potential losses, you take ‘short’ positions in a Gold ETF that tracks the overall health of the gold market.  

If the Gold price falls, you will lose money on your ‘long’ trade. But the Gold ETF should also fall, as it corresponds to the overall health of the Gold market. When the ETF falls, you will profit from your ‘short’ position. 

They won’t correspond exactly, but you could reasonably expect to offset some of the losses from your long trade with your short trade.

 

Which financial instruments can you short?

We’ve used stocks and gold as examples so far, but depending on the method you use (we’ll detail these in a moment) it’s possible to short-sell a wide variety of financial instruments, including:

• Stocks      
• Bonds      
• Indices      
• Forex (currency)      
• Commodities      
• ETFs/Indices      
• Crypto currencies (though this is only an option in certain countries, and is not currently permitted for UK traders)

And others. 

Liquidity – how easy an asset is to buy or sell - in the market may have a bearing on whether a particular asset is available to short. 

For instance, you will be able to short major indexes like the NASDAQ or the FTSE 100 on most trading platforms.  This is because there will nearly always be traders ready to buy or sell. 

However, if you want to trade an obscure penny stock, you may find it hard to find buyers or sellers. 

 

3 methods to help you pinpoint potential shorting opportunities

How can you identify which stocks (and other assets) could be about to turn down?

Identifying potential ‘shorting’ opportunities is no different to identifying potential ‘long’ trades. It’s a matter of using a proven strategy and taking the time to understand why this particular asset might be about to fall in price.

  1. Fundamental analysis. Many traders still rely on doing the ‘hard yards’ of looking into the financials of a company to hunt for signs the share price could be about to increase. Anything from a decrease in sales to declining earnings per share could indicate a fall is on the horizon. 
  2. Technical analysis. Some of the world’s most successful traders use trends as a key indicator for pinpointing shorting opportunities.  If a stock has been ‘ranging’ – consistently moving within a particular high and low – but suddenly breaks out of that range, that could be a sign there is a downward trend forming. 
  3. A suffering market. Stocks within the same market will often rise together, but they can also fall together. If a market as a whole suffers, it can be a strong indicator that stocks within that market will tumble. (And that any indices tracking the market will also fall.) 

 

How do you tell if a stock is being shorted?

The amount of information you can gather on which stocks and assets are already being shorted will vary, again depending on the popularity (and often the liquidity) of that asset. 

3 ways to check are:

  • Yahoo! Finance. If you head to the relevant stock’s individual page, you can then click on the ‘statistics’ tab. Scroll down, and you can see how many shares are currently being shorted. (This feature is only available for stocks at time of writing.)
  • Marketwatch.com holds a database of the stocks with the current highest proportion of short positions. (You can visit that database here. Be sure to conduct due diligence that the data is accurate, of course.)
  • NASDAQ.com also keeps a record of shorted stocks.  If you load up a stock’s individual page, then scan down the left-hand menu, you’ll see ‘short interest’. Click the link and you’ll see the number of short positions. (Though their database is only updated twice a month.

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4 ways to place a short trade

How to short a stock? There are 4 main ways to place a short trade. Each trading method has its own benefits and drawbacks, and which one you decide to use will depend on your own financial goals and – more importantly – your own appetite for risk.

Let’s go through them now:

 

Shorting Method 1: Short-selling as an investment

This is more an ‘investing’ strategy than a ‘trading’ one, but it’s worth explaining here, as this kind of traditional short-selling formed the basis for the others. Whenever you hear about legendary traders shorting the markets, this is probably how they did it.

Here’s how a successful short trade might work:

  1. You decide that you want to short Company A stock.
  2. You borrow 10 shares from a trading broker at a cost of £500 each. (A total outlay of £5,000.)
  3. You immediately sell those shares on at the same price and collect £5,000 from the buyer.
  4. The price of those shares falls to be worth £400 each.
  5. You buy the 10 borrowed shares back for a total of £4,000, leaving you with £1,000 profit.
  6. You return the shares to the original broker.

Of course, even if the share price goes up, you will have to buy the shares back to return them to the lender. Whatever you have to pay to buy them back above what you sold them for will be your loss.

 

This kind of short-selling also incurs a number of fees and costs, including:

  • The cost of borrowing the stock. Shares that are more difficult to borrow may have additional ‘hard-to-borrow’ fees.
  • Margin interest. Traditional short-sales can only be made using margin accounts, and margins charge interest. If you hold a short position over a long period of time, this interest can add up.
  • Dividends. Dividends might be a bonus for traditional investors, but for short-sellers they can become a problem. (We’ll cover this in more depth in the ‘risk’ section.)

As you can see, traditional shorting can be complex. That’s why many traders choose to use one of the other 3 methods, which we’ll go through now.

(IMPORTANT. The following methods are simpler to follow, but that does not make them less risky. In some cases, the following trading strategies may carry more risk than traditional short-selling due to leverage. We’ll explain more below.)

 

Shorting Method 2: CFDs

CFDs (or Contracts for Difference) are a contract between you and a broker, in which you agree to pay the difference between how much an asset is worth when you open the contract, and the current price.

CFDs are popular with many traders because they’re simple and quick to execute. (Especially compared to traditional short-selling.)

Once you’ve got the hang of using your platform, you’ll be able to place a CFD trade with just a few clicks. (Here’s a video showing an example trade.)

In terms of how you place the trade, CFDs are very similar to spread-betting, which we’ll cover in a moment. It’s a matter of stating how much you want to trade, whether you want to go short or long, and then placing the trade.

When you trade CFDs, the size of your trade will be measured in ‘lots’.

These are essentially a unit of measurement for the asset, and they vary depending on the asset itself.

For instance:

  • For Apple stock, the ‘lot’ is the price of a share.
  • For silver, a ‘lot’ will be the price per troy ounce.
  • For crude oil, the ‘lot’ is the price of 100 barrels.

When you enter a CFD, you decide how many ‘lots’ you want to trade.

So, let’s say you choose to short crude oil, because you believe the price will go down.

  • The current ‘lot price’ – the price of 100 barrels – sits at £4,000. (Each barrel is valued at £40, so 100 barrels is valued at £4,000.)
  • You decide to trade double that – 2 units/lots.
  • The price of a ‘lot’ falls to be worth £3900.
  • You close the position. The difference between the opening and closing price of the lot stands at £100.
  • You placed your trade on the value of 2 lots, so your profit (excluding fees) is £200.

 

Trading at less than the size of 1 ‘lot’.

Trading at less than 1 ‘lot’ is known in many cases as a ‘micro-lot’, and how much you can utilise them will depend on:

  • The liquidity of the asset (generally speaking, the more liquid the asset, the smaller the permitted ‘micro-lots’ you can trade
  • Your broker’s own regulations

If your chosen asset’s main ‘lots’ are small enough that you want to take a larger position, you can also trade multiples of a lot.

So, if you wanted to take a larger position in our crude oil trade, you could have traded at 4x the lot size.

How many multiples you might choose to trade at will depend on your risk profile and whether you have sufficient capital resources to cover the margin required.

 

IMPORTANT POINT.

When trading with CFDs, you do not actually own the underlying asset.

If you place a CFD trade on Apple stock, for instance, you are not an Apple shareholder. Your only financial obligation is with the CFD broker, with whom you are signing a contract to pay (or be paid) the difference between the buy price and the sell price.

Essentially, a CFD is akin to a ‘bet’ that you believe the price will move.

 

(Though it’s worth noting that unlike spread-betting, if you’re trading in the UK, you will usually be required to pay capital gains tax on profits made by trading CFDs.)

Which brings us on to method 3.

 

Shorting Method 3: Spread-betting

Spread-betting is another method popular among traders for its simplicity, and – as we just mentioned – because any profits made on spread-bets in the UK are tax-free.

It’s also simpler to understand than the ‘lots’ within CFDs.

Spread-betting is, as the name suggests, a straight bet on the direction of the market price. When shorting, you are simply placing a bet the markets will fall.

When you sign into a spread-betting account, the asset value you see at the top of the page will be the same as it would in your CFD account.

However, with spread-bets, you don’t trade multiples of ‘lots’. Everything is measure purely in points. (Or ‘pips’.)

When you place your bet, you will be asked to determine how much you would like to wager per point.

The more you choose to bet per point, the more you risk losing if you’re wrong about the trade.

Here’s how a typical profitable shorted spread-bet will work:

  1. You decide to short the price of crude oil, which is currently at 1,700 pips.
  2. You choose to bet £3 per point, and place your trade.
  3. The price of crude oil falls by 250 points, and you close your trade.
  4. Because you bet at £3 per point, your profit is £750.

However, you will also lose £3 per point if you’re wrong. In this example, if crude oil had risen by 1,000 points, you would have lost £3,000.

It’s very important to understand that the markets can move surprisingly quickly, which means you can suffer heavy losses fast.

The more you wager per point, the more your losses (and any potential gains) are magnified. This is what we mean by ‘leverage’ – you’re leveraging your position to try and maximise any gains.

 

WARNING. Leveraging your position can be very risky, and isn’t recommended for less experienced traders. (Many experienced traders still choose to avoid it entirely.)

 

As with CFDs, spread-betting trades are simple to execute. (We’ve got another video example here.)

Traders in the UK also benefit from the fact that spread-betting is officially classed as gambling under UK law, making any spread-bet profits tax-free.

What if you decide that this kind of leveraged trading carries too much risk for you, but you still want to be able to place short trades?

That brings us onto our final short-selling method:

 

Shorting Method 4: Inverse Equities

Many traders prefer to take a more cautious approach to trading by using ETFs. ETFs are funds that track the overall performance of a particular market.

So, if you believe that the FTSE 100 will perform well over the next year, you can place a long trade on the iShares Core FTSE 100 ETF. Broadly speaking, this will allow you to spread your risk across the 100 companies that make up the index, without investing in them all individually.

How does this relate to shorting? Because there are a growing number of ETFs that are also known as ‘inverse equities’. That is, they track the downward performance of a particular index.

You can choose to invest in inverse equities. These are still essentially ETFs, but they track the downward performance of an index.

So, a reverse equity ETF tracking the FTSE 100 will go up when the index itself goes down. And vice versa.

Here’s a visual:

 

 

You can see the black line represents the performance of the standard ‘long’ ETF, and the grey line represents the performance of the inverse (‘short’) ETF.

When the index is performing well, the ‘short’ ETF falls, and when the index falls, the inverse ETF moves upwards.

(You’ll notice that they aren’t an exact mirror image. That’s to be expected. ETFs will vary slightly in how they perform due to variations in how their portfolios are constructed.) 

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What are the key short-selling risks?

Short-selling can be a powerful trading tool. But it carries inherent risks that go above and beyond the risks you might encounter when placing a standard ‘long’ trade.

Please read the following section carefully. We’re going to detail all of the main risks you need to take into account when shorting.

The four different methods we’ve covered above all carry individual risks unique to them, and some of the risks are shared across all the strategies.

 

1. You’re going against the prevailing market trend (relevant to: all methods)

If you look at the history of the markets, you’ll see that – broadly speaking – stocks always trend upwards over the long term. As you’ll see from this chart of the FTSE 100 index across the past 30 years:

 

FTSE 100 index across the past 30 years.png

 

There are multiple dips and several major corrections, but over the long-term, the market has continued to grow over this period.

This means that when you short, you’re broadly moving against the overall direction of the market if you plan to trade over a longer period.

In other words, successful consistent shorting is very challenging. (Which is why many very experienced traders still avoid it entirely.)

 

2. Regulatory changes can cause problems (relevant to: all methods)

Short-selling laws vary massively depending on the market. And even in countries where short-selling is legal, it’s not unheard of for governments to change laws and regulations.

For instance, at the height of the 2008 financial crisis, both the US Securities and Exchange Commission and the UK Financial Services Authority temporarily prohibited short selling in financial stocks to try and prevent further damage to the sector.

During the Covid-19 pandemic, a number of European nations including France, Italy and Spain took similar actions to try and protect their stock markets. (Though some analysts  .)

This kind of government action is relatively rare, but it’s still worth consideration if you plan to make shorting a regular part of your trading strategy.

(These bans do not always apply to other methods of short trading. The 2008 ban on shorting financial stocks did not apply to CFDs for instance.)

 

3. Short-selling means your losses can be potentially unlimited (relevant to: all methods)

As Warren Buffet once put it, "If you buy something at $20, you can lose $20. If you short at $20, your loss can be infinite."

Let’s say that Company A’s value stands at 1,000 points. So, you take a ‘long’ position, betting that the price will go up.

Unfortunately, the company collapses and the price falls to zero.

You’ve lost 1,000 points on your trade. A heavy loss. But your loss is always limited because the share price can’t fall further than zero. The difference between the value of the stock now and zero is your maximum loss.

When you short, there is no limit to your potential losses.

 

Example: You bet Company A’s stock will fall in value and decide to short the stock.

The next week, Company A announces it is being purchased, and the stock shoots up by 5,000 points.

Your loss is now 4,000 points. And if the company continues to perform well, your loss could increase. The stock could increase in value by another 5,000 points. Even another 20,000.

 

And remember, if you’re trading CFDs or spread-betting, you may be leveraged. Even a 500-point loss could mean a loss of thousands.

That’s why It’s so important to understand the importance of leverage, and how to manage it.

NOTE. Many traders make use of stop-losses (or stop-orders) to cut trades automatically once they hit a certain loss point. For a full briefing on effective stop-loss and stop-limits,

 

4. Dividend pay-outs can cost you money (relevant to: CFDs, spread-betting, traditional short-selling)

If you’re a traditional, long-term trader, then dividends can contribute a lot to your success.

Dividends are payments made regularly to shareholders, usually calculated based on a ratio called ‘Dividends-per-share’. The maths behind this is quite complex, but what you need to know here is that they are usually paid out at regular periods to shareholders.

So, if you hold £10,000’s worth of shares from Company A, you may receive payments of £250 four times a year.

That might not sound like a massive amount, but dividends can add up substantially over the long-term. 

Unfortunately, if you hold a short position, dividends can work against you. Depending on your trading method, owed dividends may be deducted from your trading account to pay the stock owners. In other words, you may be required to pay the dividends yourself.

Depending on how long you hold the position, this can substantially eat into your profit margin.

 

5. Short-squeezes (relevant to: all methods)

In 2021, a small group of traders centred around the sub-reddit r/wallstreetbets started one of the notorious ‘short-squeezes’ in history.

Investopedia defines a ‘short squeeze’ as:

“A market phenomenon in which an unexpected rise in the price of a heavily shorted stock prompts large numbers of short sellers to exist positions by buying up the stock, thus driving up the price further.”

Gamestop’s share price had risen to around the $20 mark in January, much higher than the $5 it had settled around for most of the year. A number of hedge funds took short positions in the stock, expecting the stock to return to its lowest levels.

Wallstreetbets had other ideas. The group worked together to buy up Gamestop stock on a massive level, sending the stock price rocketing up to a peak of $492.02.

The hedge funds were forced to buy back as much stock as they could to try and minimise their already monumental losses. One hedge fund – Melvin Capital – was forced to close its doors entirely, simply unable to recoup what they’d lost on their short positions.

Short-squeezes are relatively uncommon, but as Gamestop proved, they can devastate traders within a very short space of time.

 

What is Shorting in Trading

 

6. Margin calls (relevant to: all methods)

To become a successful trader, you’ll have to become very familiar with the term ‘margin’.

Margin, simply, is the collateral you’ll have to deposit with a broker to cover the broker’s credit risk.

It is the gap between the value of the trade you’re going to make and the amount the broker will ask you to deposit as part of the trade as ‘security’ against potential losses.

 

For example. If you want to place £1 per point on a share worth 190 points, the value of your trade is £19,100.

If the margin ratio is 5:1, your margin will be 20% of the trade value. So, in this case, you will be required to have at least £3280 deposited in your account. This is your ‘margin’.

 

Trading brokers will always require you to have a certain amount of equity in the account. (Equity meaning the total capital you have deposited, plus or minus any profits or losses.)

A ‘margin call’ is when your total equity falls below the broker’s required margin. When this happens, you will usually be required to add more capital to your account to rectify the problem.

Again, there is theoretically no limit to how much more capital you might be asked for. The more you fall below the required margin level, the more the broker can ask you to provide to make up for the shortfall.

 

7. Costs and fees can increase mid-trade (Relevant to: traditional short-selling)

We mentioned earlier that purely borrowing a stock will mean you can incur ongoing fees and costs.

Unfortunately, these costs are rarely fixed. They can change quickly depending on market conditions.

Though the ‘standard’ market costs for borrowing stock tend to hover around 0.3%-3%, it’s not unheard off for costs to increase by multiple tens of percent if supply and demand within the markets shift.

(It’s also possible for the value of the stock you’ve shorted to skyrocket the same time as the accompanying interest rate, which could mean substantial losses.)

 

Shorting: is it ethical?

As you’ve seen, shorting can be lucrative. It also carries massive risks. Many experienced traders prefer to avoid it entirely.

Whether you choose to add it to your trading strategy is up to you.

But there’s one final additional point to consider:

By shorting, you’re technically rooting against the markets. In some cases, against individual companies.

Some traders see this as best irresponsible, and at worst unethical. They see short-sellers as not just taking advantage of a fall in price, but actively making the situation worse.

Traders who do short-sell would argue that, actually, short-selling is a key part of making sure assets are valued correctly.

If a stock is shorted by a number of traders and the price is pulled down, that is a fair reflection that a certain percentage of the market believes the stock is not worth owning.

If short-sellers weren’t providing this indicator, the asset price could become over-valued and risk less-informed traders losing their capital.

 

So, let’s summarise everything we’ve covered here today:

  • Shorting is a way of trading that allows you to profit when an asset decreases in value.
  • It can also let you ‘hedge’, meaning you can potentially recoup losses on ‘long’ positions.
  • Depending on the method used, you can short a wide-range of financial assets, including stocks, bonds, indices, FX, commodities and ETFs.
  • 3 main techniques for pinpointing short opportunities are fundamental analysis, technical analysis and looking for markets in which many other assets are suffering.
  • There are 4 main methods for placing a short trade: traditional short-selling, CFDs, spread-betting and using inverse equities.
  • Key risks for short-sellers include: going against the prevailing market trend, regulatory changes, potentially unlimited losses, having to pay out dividends, short-squeezes, additional costs and fees and margin calls.

 

So, how can you try shorting a trade without risking your money?

At markets.com, we offer award-winning trading services for both CFDs and spread-betting. We’re delighted to say that as part of opening an account with us, we provide a full DEMO account, complete with a £10,000 pot. (Not real money.)

You’re not required to fund your account with real capital before making trades with your demo account. This means that you can practise opening and closing short (and long) positions, without risking any real money. You made decide that shorting (and even trading) is not for you, in which case you can decide to be one of the many traders who choose not to do it.

Or, if you prefer, you can then fund your account and start to place trades for real as and when it suits you. If you’re interested in trying a DEMO account with markets.com, click here and you’ll be taken straight to our registration page.

 

If you’re interested in trying a DEMO account with markets.com, click here and you’ll be taken straight to our registration page.

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