Most people think about trading in just one direction; they imagine buying an asset (‘going long‘) before the price begins to rise, then selling it just as it reaches its peak to reap a profit. While this is an excellent goal for any trader to aim for, it’s by no means the only potential way to capitalise on market movements. It is necessary to understand the different between long and short trade. Opportunities can also arise in markets that are heading for a downturn, and in this blog post, we’ll see how you can trade these by ‘going short‘ or ‘short selling‘.
Going long vs going short
When you go long, you open a trade by buying an asset whose value you expect to rise and close it by selling, hopefully for a higher price. To go short, you do the opposite; you sell to open a short trade and buy to close it. If you believe an asset’s price is set to fall, you might decide to sell it now in the hope of later buying it back at a lower price to make a profit. For example: Let’s say that shares in XYZ plc are trading at 1000p. Jonathan decides to borrow 100 XYZ plc shares from his stockbroker to short sell, as he believes the price will soon fall. Jonathan’s broker lends him the shares, sells them for Jonathan and credits his account with the proceeds (£1000). XYZ plc’s share price then falls to 800p, and Jonathan decides to close (or ‘cover’) his trade. The broker buys 100 shares for him, deducting the purchase cost of £800 from his account and returning the shares to their original owner. This leaves Jonathan with a gross profit of £200 in his account. His broker will also charge commission for handling the transaction, the lender will require a borrowing fee, and there could be other costs for the trade.
Why sell short?
There are a number of reasons for short selling:
If you opened a speculative short position, your intention would be to profit from a potential downturn in the market. Speculative short selling enables traders to stay active, even in bearish markets. However, trading in this way does mean assuming a high level of risk; your loss is theoretically unlimited. Suppose you sell 100 shares short at a price of 1000p: your maximum profit is £1000 if the stock sinks to zero. However, if the price rises to 4000p, your loss is a painful £3000 – and could keep increasing indefinitely if the stock keeps going up. There’s no limit to how high the price might go, after all. So it’s important to manage your risk when short selling. Speculative short traders can be beneficial to the market, increasing trading volumes and liquidity. However, they can also influence market movements, even contributing to market crashes. In 1992, George Soros speculated that sterling would fall after a prolonged period in which the British government artificially propped up its value. Weakened by short-selling pressure, including large trades by Soros, the government’s policy became unsustainable. Britain withdrew from the European Exchange Rate Mechanism, causing the pound to plummet. By risking $10 billion in short positions, Soros made $1 billion overnight, and his eventual profit was nearly $2 billion.
While speculators take on risk, in contrast hedgers seek to protect themselves against it. Taking a short position is a common strategy to offset (or ‘hedge’) the risk of adverse price movements in a long position you hold. In brief, the idea is that if your long position makes a loss, your short position will make a profit to compensate. For example, if you own a selection of stocks from the FTSE 100, you might take a short position on the FTSE index as a whole to offset potential losses should the market fall. You’ll still see a drop in your share portfolio, but your short position on the index itself will help reduce the overall loss. So a hedge is like a form of insurance. Like any insurance, it has a cost; if your long position makes a profit, the short hedge will normally make a loss that reduces it. However, traders often feel the protection offered by the hedge makes this worthwhile.
Risks to note
Selling short can be a useful way to capitalise on market trends and potentially turn a losing situation into a profitable one, but with these benefits come risks that should be taken into consideration before you start trading. The primary risk with short selling is since you typically sell short when you expect an asset’s price is set to fall, you risk losing a lot of money if your predictions are wrong and the asset’s price starts to rise- your losses are potentially unlimited, as there is no upper ceiling for a stock’s price. As mentioned above, speculative short selling comes with potentially high levels of loss if your speculations are incorrect, and speculations at a large scale can influence the market in ways that can cause crashes. Short selling is a valuable tool in an experienced trader’s belt, but something that beginner traders should do a lot of research into before attempting. Keep a close eye on market trends and stay up to date with how prices rise and fall, and keep your trading safe and start small with your short sells before going for bigger profits.