Shorting a stock in the UK

Key points

• Short sellers are betting that a financial instrument is due to decrease in value

• The aim is to sell the asset at a higher price and buy it back when it has dropped to a cheaper price, locking in profit

• Shorting can be an effective way of hedging your bets against losing long positions

• Traders can use this technique for assets such as indices, currencies and commodities, although the stock market is perhaps the most popular

• This approach can bring profit for experienced traders, but risks major losses

What is 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.

How does shorting a stock work?

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.

Traditional brokerage

When shorting a stock via a traditional broker, traders borrow shares they do not own. These shares are usually lent from their financial broker. The trader then sells the borrowed shares at market value. The trader aims to repurchase the same shares at a lower price and return the shares to the lender. If the price of the stock drops, short-sellers profit from the difference in price between the rate they borrowed at, and the rate they repurchased the shares.

This method does come with some caveats, but namely that it is up to the broker to decide if the share can be shorted. However, say that you can find a broker to lend you a stock to short, you will most likely have to pay borrowing fees as well as any dividends paid by the borrowed stock. Given the costs and the complexity of short selling, it is often recommended for experienced traders. There is, however, a more accessible way to short sell stocks known as leveraged trading.

Leveraged trading

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

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).

CFD trading

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.

How to short a stock in the UK

To short a stock with a spread betting or CFD trading account, you can follow these simple steps to get you started:

1. Open a live CMC trading account - You can begin to short stocks with our spread betting or CFD leveraged trading accounts. See the differences between CFDs and spread betting if you are not sure which to choose. Our leveraged trading accounts are also available as a demo account in a risk-free environment for all customers.

2. Find the right stock to short - Make use of our news and analysis section, to inform yourself of market turbulences that could precede stock crises. Also, see our fundamental analysis resources that could help you determine which companies are likely to struggle.

3. Manage your risk - Before you place a trade, make sure you have adhered to suitable risk management strategy. Read more on managing your risk here.

4. Go 'short' and sell - Choose a position size in line with your trading strategy and place a 'sell's order ticket request to short-sell your chosen stock.

Best times to short a stock

Finding the right time to short a stock can be the difference between good and bad short selling. Generally, it is dependent on a trader's strategy to find effective market entry and exit points. Our guide to stock market trading hours will also help you to determine the right time of day to place a trade.

Most traders will use a combination of strategies to determine when they will enter the market, but it varies distinctly between technical analysts and fundamental analysts.

Technical analysis

Technical analysts could short a stock based upon what direction the general trend is heading. Using simple trend line indicators, technical analysts would analyse the trend direction of a share or stock. If the trend showed no signs of slowing down, it would present a key opportunity for technical analysts to ride the trend downwards.

Technical indicators such as the simple moving average (SMA) or exponential moving average (EMA) can provide key insight for technical analysts. Stocks that drop through prominent support points or fall below major moving averages (e.g. 200-day moving average) may continue on a descending trend.

Fundamental drivers

Missed earning reports present a big opportunity for short-sellers. If a company profit does not meet profit estimations, it is likely to be underperforming in certain areas. This could cause a large number of investors to start short selling. However, it is often best to look beyond just earning reports, as a company may be underperforming for reasons that do not impact its stock price.

Declining industries provide another opportunity for short-sellers. Industries that have experienced a general downtrend due to innovations in other markets or negative client sentiment can cause a particular stock's price to plummet. When an industry is perceived as obsolete, companies in that competitive space can be left with dwindling growth prospects, causing short sellers to take advantage.

Overvaluation is a common factor that can cause short sellers to come together. Stocks that are constantly covered in the news can cause the price to hyper-inflate relative to the stocks actual value. Once the price 'bubble' bursts, short sellers will come together knowing that the stock is not worth its current market value.

However, please note that a stock's fundamental values are not sole determinants of its price. There are various factors to consider when shorting a stock, and these factors form a complex picture. Each trader should do their own research when considering to trade stocks.

Shorting a stock example

For example, let us say that you wanted to short Apple (AAPL) via CFD trading.

Apple is currently trading @ $300.

You open a position to "sell" 10 share CFDs @ $300. Your total market exposure is now $3,000.

CFDs are leveraged, meaning you only need to pay a deposit of the full trade amount to open the trade. The margin rates for shares are 20%, meaning you have to deposit $3000 x 20% = $600 margin requirement.

A profitable trade

• The market has fallen as you predicted. Apple is now worth $250.

• You close your position with 10 share CFDs @ $250. You take away $2,500.

• Your total trade value was $3,000, but it is now worth $2,500, a $500 profit*.

An unprofitable trade

• The market has risen, opposite to your predictions. Apple is now worth $325.

• You close your position with 10 share CFDs @ $325. You take away $3,250.

• Your total trade value was $3,000, but it is now worth $3,250, a $250 loss*.

Benefits of shorting a stock

• Hedging risks - Using short selling to offset the risks of other assets in your portfolio is a known strategy for savvy long-term investors. Hedging your other positions by short selling can reduce your overall risk exposure. Say, for example, you purchased some shares in Google and intended to hold them for 10 years to profit from the companies expected growth. If any short-term disruptions impacted the rising trend of Google share price and it started to fall, you could hedge your investment position by short selling. This way, any losses that exist for Google's shares can be reduced by the profits of the short sell.

• Opportunity - Most financial markets are volatile and sensitive to external forces. Having the opportunity to take a position on both sides of the market can be more useful than only having access to buying opportunities.

• Market crashes and recessions - Short selling provides one of the few opportunities to profit from declining markets and recessions. Without having the ability to short a share, profit opportunities would be limited to periods of market growth.

Risks of shorting a stock

• Limited profit and unlimited loss - When shorting a stock through a broker the maximum profit you can make is limited as a stock cannot surpass being worthless. Additionally, losses can be hypothetically unlimited as there is no limit to a rising stock price. However, when leveraged trading, the use of stop-loss orders

  can be used to manage this risk.

• Short squeeze - When a group of short-sellers make an incorrect decision to short a stock, they can panic and sometimes buy back the stock they were shorting. This increase in market activity can cause buying pressure that pushes up stock prices. Losses are realised for short-sellers when the market turns in the opposite direction of what they suspected.

Summary

Short selling can provide a great opportunity for many traders, as being able to play both sides of the market increases the chance of finding markets that match your trading strategies. Additionally, the ability to short a stock via a leveraged trading product provides a more streamlined process in comparison to conventional methods to short a stock.

When learning to short a stock, you must take into account the risks that arise with leveraged trading. Features such as guaranteed stop losses and negative balance protection can be particularly useful when attempting to mitigate your risk exposure. These features can provide a larger margin of error in comparison to conventional short selling. Visit our guide on risk management for more information.

View our article on undervalued stocks for more strategies that can be applied to trading stocks and shares.

You can practise short selling stocks on a leveraged trading demo account here.

*This does not consider the commission charges. When trading shares via CFDs a commission cost is incurred, see our CFD commissions article for more information.