What is Short Selling?
Short selling is the act a trader takes in selling a stock or instrument in the hope that it decreases in value. Traditionally, especially in physical markets, traders or investors did not have the ability to sell without first owning the underlying asset. However with the introduction of digital brokers and the popularity of CFDs more and more traders jumped on the opportunity to sell markets they had no ownership in.
Although very simple, the concept of short selling is a topic many new and experienced traders still struggle to fully get to grips with. We break down this topic below to allow traders of all levels to better understand it’s full working.
How does short selling work?
Short selling works as follows. When a trader shorts an instrument they are essentially entering an agreement with a buyer, selling at their requested price, and anticipating the markets price decrease to take place meaning they sold high, and bought low prior to delivering the asset to the purchaser.
Here are 2 examples of how this works. I will give one generic example and 1 example relating to a trade.
Example 1
Okay so imagine you are a car dealer, your job is simply the sale of vehicle. Lets imagine you have a customer who wants a 2019 BMW, you sell this for £10,000, and the delivery date is for 1 month from the date the sale took place. In the time between the sale and the delivery, you try to find someone else selling the same car for £8000, you buy this from them and sell it on to the buyer for £10,000, meaning you secured a £2000 profit.
Example 2
Now we get a basic understanding, let’s look at it from the markets perspective.
You are trading Crude Oil. You believe there will soon be an oversupply and you want to sell. Via CFDs you say $55.90 is the price from where you believe the value will fall. You have agreed a price of sale with a buyer, highlighted by the red arrow, now you wait for the market to go down to the red tick. Once it does you buy Crude at the lower price of $53.55, knowing you already have an agreement to sell at $55.90. Your profit is the difference.
Strategies for short short selling?
Regardless of the direction you believe the market may move, most traders are likely to have a range of strategies that assist in making these decisions. Deciding where to enter is no easy feat. So below look at a few basic strategies traders who short sell use for there entry positions.
Strategy 1 – Selling at resistance.
Most traders believe the resistance level is the price point where we see markets usually start to fall after a bull run. As a result a lot of traders will place a sell order at this level as they believe it will be a good point on entry.
Below you see how firm the resistance is held, each time the markets hit the resistance, we see a selloff takes place.
Strategy 2 – Selling at Overbought – Relative Strength Index.
With the RSI traders traditionally look at the level of 70 and above to be Overbought, so whenever the markets near that level we traditionally the potential for shorting increase.
As you can see below, each time the RSI hits or gets close to 70, the trend heads downwards as the selling volume begins.
Pros and Cons of Short selling
Pros
- Diversification
- Profit not only when markets are up
- Can use to hedge longer term investments
Cons
- Profiting from a decline in stocks
- Pessimistic approach to investing
- High risk in shorting stocks, which historical rise
Best Brokers for Short Selling?
The best brokers for short selling are usually those who allow hedging, have low spreads, good execution speeds and generally reliable. Short selling can be one of the riskiest areas to place a trade especially in stocks, so brokers would need to offer the above and more, to help ease your mind when trading with them.
Here is our list of the best brokers for shorting:
