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For many people who are unfamiliar with the mechanics of investing, the general perception when it comes to market performance is very simple: markets go up, people make money. Markets go down, people lose money.
While this isn’t altogether untrue, it doesn’t necessarily mean that you can’t profit from a market downturn, which is something many beginner investors might be unaware of.
This is where short selling comes into play, with experienced investors using this as a method to take advantage of market downswings, or to hedge their risk against long-term positions they have. Some people might have thought that the recent Brexit stalemate might have been a good time to take advantage of a predicted decline in the British Pound (GBP) against the Euro (EUR). If the GBP drops versus the EUR, you then make money if you have placed a position to short the Pound.
But what exactly is it and how can you go about executing short sell trades?
What is short selling?
Short selling is the sale of a security such as a stock, bond or option that you, the seller has borrowed. How does that happen? This is usually done through a broker. The broker “lends” you the shares that are sold, and you close your short position by buying the shares back and returning them to the broker.
Let’s say you were to think that Stock A’s price will drop. You borrow 50 shares from your broker and proceed to sell them. You are now “short” of 50 shares (because those shares weren’t yours to begin with), hence the term short selling.
As an example, let’s say Stock A is currently trading at $10, and you think it will drop further. A week later the stock drops to $8 and you decide to close your position and buy those shares. Your profit on the sale is thus ($10-$8) x 50 shares = $100. If, on the other hand, the price of the stock went up to $15 and you decided to close your position, you would make a loss of ($15-10) x 50 = $250 because you had to buy back those shares at a higher price than when you sold them.
How can you short sell shares?
Typically, as mentioned above, people go through brokers to short sell shares. However, it must be noted that when it comes to short selling of actual shares, this is also dependent on the availability of that stock. Remember that because you are borrowing the shares, if the stock is already heavily shorted by other traders, there might not be enough supply for you to borrow.
Also, it’s very important to note that just because you sell a stock short doesn’t necessarily mean that you can just buy back that stock whenever you wish. As with everything else in the stock market, there has to be a market for any given stock i.e. there needs to be people willing to sell that stock.
So what else can you do? This is where a Contract for Difference (CFD) comes into play. With CFDs, you can also take advantage of drops in the market without having to actually buy shares. As the name suggests, you can benefit from the difference in the contract, and you can trade on price movements in either direction.
If you want to know more about how CFDs are traded, you can check out our summary on trading CFDs and the myths behind them here.
How can you get started?
As the world’s number 1 CFD trading platform, IG has a well established trading platform that is used by both seasoned and beginner investors alike.
One of the important things to note about short selling is that there is a risk involved because you essentially owe someone something. As we wrote about previously, sudden market crashes aren’t anything new, but things can just as easily move in the other direction. IG provides risk management tools that allow you to manage these swings, which you can read our article about here.
You can easily create an account and even try out trading with a demo account that allows you to hone your skills and strategies before putting actual money in. They’ve also just released a free e-book in collaboration with Bloomberg that will give you more insight into the world of CFD trading.
What are your thoughts on short selling? Share them with us here!
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