A complete guide to short selling

Essentially, short selling is betting that an asset will lose value. The aim is the same as any other short-term trading strategy​ — to sell for more than you buy — but shorting means you sell the asset before you buy it.

For example, after identifying a company whose share price might drop, the trader could open a short position on a number of shares in that company from a broker and then sell them at the market value. If the trader has predicted correctly and the share price goes down, the trader can buy those shares back at the reduced price and make a profit, before returning them to the lender. If the price rises, however, the trader potentially is forced to buy the shares back for more than they paid, thereby making a loss.

Many investors profit from bullish markets. They invest in companies they expect to grow based on optimistic views. However, more short-term traders attempt to profit from declining asset prices and market crashes. These dealers prefer to speculate on negative market sentiment, such as a bear market​.

Traders may short stocks for a number of reasons. The first and most common is to make a profit, but this ‘sell high, buy low’ approach can also be an effective way of hedging​ — that is, taking two differing positions on the same stock so the gains from one can offset the losses from the other. For instance, many traders might hold a long position on a stock (buying it to sell later at a higher price), but because that stock is declining in value, they might choose simultaneously to short the same stock to take advantage of that diminishing share price. The profits they gain from the short will mitigate the losses they’re experiencing from their long position — literally cutting their losses.

In order to practise a short selling strategy with us, our clients must trade with leverage. This means putting down a deposit, known as a margin, to gain exposure to much larger trading positions, but without directly owning the underlying stock, commodity or currency pair.

Because you are not borrowing the stocks themselves, this is called derivative trading. This gives the potential for much higher profits, but also much higher losses. The two main types of leveraged trading that we offer are explained below.

Spread betting​ is a form of derivative trading that allows you to place a bet on which direction you think a stock will move, speculating on price changes. Depending on whether the market moves in your favour or not, you stand to make a profit or loss. Spread betting is tax-free in the UK and Ireland* and also comes with zero commission charges on share profits (other fees apply).

Contracts for difference (CFDs)​ are another popular method of leveraged trading. CFD traders speculate whether they believe particular stocks will fall or rise by entering a contract stipulating the buyer must pay the seller the difference between an asset’s current value and its value when the contract expires. CFDs are available globally but are subject to capital gains tax and commission fees.

If you choose to trade CFDs, you’re entering a contract agreeing to exchange the difference in the opening and closing positions of your chosen asset. Say, for instance, shares in the fictitious Banana computer company are trading at $200 each.

You think the shares are overvalued and the price will fall, so you choose to short 100 share units, the price drops to $180 and you close your position. This gives you a profit of $2000 – that is, the difference between the opening and closing position multiplied by the number of shares ($20 x 100).

Later that day, another computer company, Lemon, is trading at $150, and because you think that price will fall too, you short 100 share. But this time you’re wrong, the price goes up and by the time you exit, it’s $160 per share. The difference between opening and closing is $10, you have 100 shares, so on this occasion, you’ve lost $1,000.

An advantage of betting on an index is that, unlike a company, it won’t go bust or be vulnerable to internal or industry disruptors. It is more likely to be affected by macroeconomic factors that affect the whole market (Covid-19, for instance, wiped billions off indices worldwide). The principle is the same — when shorting the market, you’re predicting whether the total value of the index goes up or down.

For instance, you decide to short our UK 100 instrument (based on the FTSE 100) by betting £5 per point that it will go down. If the index starts at 5,880 and then falls 50 points and closes at 5,830, your profit is 50 x your £5 stake per point, a total of £250.

However, if it had gone up 20 points and you exited at 5,900, you’d have lost £100 — those 20 points x your £5 stake.

You can place CFD trades on foreign exchange (forex) by betting on how two currencies will fair against each other — for example pound sterling and the US dollar. If you short sterling​, you are hoping it will fall against the dollar. If you short the dollar, you are hoping the opposite will happen.

Let’s say that when you open your position, GBP/USD is trading at 1.23015. You decide to sell at 1.2301. Selling a single unit of GBP/USD is essentially the same as trading £100,000 for $122,015. You think the GBP will fall so you decide to sell five CFD units, giving you a total position size of £500,000 or $615,050.

You’re correct, the pound falls to 1.122015 and you close your position, buying those five CFDs back at the new buy price of 1.12202, closing the trade at $610,100. Because you sold at $615,050 and bought at $610,100, you’ve made a profit of $4,950.

However, if you’d been wrong and the pound rose to 1.24015, you close at the new ‘buy’ price of 1.2402, which means buying your five CFD contracts at £620,100, resulting in an overall loss of $5,050.

Short selling incurs several costs. These will eat into any profit you might make, so it’s worth taking these into account before you decide to trade. Leveraged trading costs can include:

A perception that a stock is overvalued is a key reason to why a trader will short a stock, as they anticipate the market will eventually cotton on and the price will fall. This perception can result from scepticism about a new technology or trend and can sometimes lead to a sudden stampede of selling, increasing a company’s short percentage of float (the percentage of open market shares that have been borrowed to short).

This is often immediately followed by a reactionary short squeeze as groups of investors flood in to buy and prop up the stock, or by a sudden realisation that the short sellers were all wrong, that particular trend or technology is the future after all, and the stock wasn’t overvalued.

What is considered a high short percentage is subjective, but 20% is generally considered a significant figure. Noteworthy companies with recent high short percentages include:

The short interest ratio (SIR) represents the average number of days it takes short sellers to buy back all their borrowed shares. Also called the ‘days to cover ratio’, it gives a measurable indication of the short interest in a stock.

The ratio is calculated by dividing the total number of shares currently sold short by the stock’s average daily trading volume. A low SIR indicates wide availability of shares and therefore a relatively stable price, but an increasing days to cover ratio indicates short sellers might be struggling to buy back and close their positions, because of an increase in demand and/or a potential price spike. A rising SIR can therefore often be an early indicator of a short squeeze and an opportunity for a fast-acting trader to make a quick profit.

For instance, if Company A has 6,000 shorted shares and its average daily trading volume is 2,000, its SIR (6,000 divided by 2,000) is three, meaning it would take short sellers three days to buy back and exit their positions. But if the average daily trading volume halved to 1,000, this makes it harder for short sellers to buy back quickly, increases the SIR (6,000 divided by 1,000) to six and pushes the share price up – putting even more pressure on the short sellers to exit quickly.

When shorting the markets, the focus isn’t all on stocks – many traders short forex by spread betting on the difference between a pair of currencies (that is, predicting one of the pair will decrease as the other increases); others use spread bets to short an entire index. But in all trading, the secret is to find the right asset at the right time.

Starting to trade with us is a fairly straightforward process for both beginners and experienced traders. Our Next Generation trading platform, educational resources and supportive client services team all help our clients to truly understand the markets, enabling you to realise your potential and make the most of your trading experience.

Are you new to trading? Set up your own demo account, which gives you £10,000 of virtual funds to practise trading with before you commit to the real thing. You will have unlimited access to our product library of indices, commodities, currencies, bonds, ETFs and share baskets, and one month exclusive access to our stock library before you’ll need to transition to a live account and deposit funds to continue short selling stocks.

Follow our step-by-step platform tutorial on how to start trading using our bespoke platform and tools.