Many investors and traders profit from bull markets. They invest in companies they expect to grow based on optimistic views. However, some dealers attempt to profit from declining share prices, struggling businesses and market crashes. These dealers are known as “short sellers” and prefer to profit from negative market sentiments, such as a bear market.
There are various ways to short a stock. In this article, we investigate how to short a stock via leveraged trading, and key signals when deciding what stock to short. Shorting stocks is more complex than trading based on optimistic market attitudes. Therefore, it is important to understand how to get started short selling and the implications of doing so.
Most investors aim to benefit from stocks or shares that are forecasted to have the potential for future growth and development. However, short selling or shorting stocks is a trading technique that involves profiting from the decline of a company’s share price.
Traders who follow conventional trading strategies are usually looking for markets that are becoming more relevant or companies that are outperforming the market average. However, short-sellers do the opposite. They look for shares that are underperforming in the market or shares that could become less relevant in the near future.
Unlike most traders who like to buy low and sell high, short-sellers adapt the order of this philosophy and aim to sell high and buy low. Short selling is a complex topic, and there are many things to be mindful of when shorting a stock. A stock can be shorted in two ways, with a traditional brokerage or a leveraged trading provider, which are explained in more detail below.
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.
When traders short sell via leveraged trading, they do not own the underlying stocks. Spread betting and CFD trading are two types of leveraged trading with many similarities and some unique differences. However, both products offer the trader an opportunity to take a ‘sell’ position on shares and profit from stock price downfalls without the need to borrow physical stocks. With leveraged trading your profits and losses are magnified by your leverage ratio.
Spread betting is a popular form of leveraged trading which is available only in the U.K. and Ireland. Spread betting involves traders placing a bet on which direction they think the stock market will move. This method of leveraged trading provides an efficient method to short a stock without having to wait to borrow stock. Additionally, spread bet profits are commonly tax-free*. However, the spread is a key cost when shorting stocks via spread betting. View our competitive spreads across thousands of stocks and ETFs here.
CFD trading is an alternative to spread betting and is the most popular method of leveraged trading. CFD trading is available globally, providing an efficient method to short stocks from most countries. Similar to spread betting, CFD traders speculate whether they believe the market will fall or rise, receiving profit for correct speculations and incurring a loss for incorrect predictions.
To short a stock with a spread betting or CFD trading account, you can follow these simple steps to get you started:
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 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.
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. This can also be affected by political and economic events such as presidential elections and trade wars. 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.
For example, let us say that you wanted to short Apple (AAPL) stock 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.
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*.
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*.
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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.
*This does not consider the commission charges. When trading shares via CFDs a commission cost is incurred, read our article on CFD commissions for more information.
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