How to short sell a stock

Published on: 08/10/2021 | Modified on: 01/02/2024

Shorting a stock is a trading strategy that allows investors to profit from a decline in a stock's price. While most people are familiar with buying a stock and holding it in the hope that its value increases, short selling involves borrowing shares from a broker and selling them on the market, with the intention of buying them back at a lower price in the future. This practice may seem counterintuitive, but it can be a valuable tool for traders looking to capitalise on downward trends in the market.

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Reviewed by

Michael Hewson

Chief Market Analyst

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What is short selling?
How shorting works
How to short a stock: a step-by-step guide
Advantages and disadvantages of shorting stocks

What is short selling?

Short selling, also known as shorting, is a technique used by traders to profit from a decline in the price of a stock. When you short a stock, you’re essentially speculating that its price will go down. The process involves borrowing shares of a stock from your broker and immediately selling them on the open market. You then wait for the stock's price to drop, and when it does, you buy back the shares at the lower price and return them to your broker. The difference between the selling price and the buying price is your profit.

How shorting works

Let's consider an example to illustrate how short selling works in practice in the underlying market. Suppose you believe that Company XYZ's stock is overvalued and will decline in the coming weeks. You short 100 shares of Company XYZ.

A few days later, as you predicted, the stock price drops from £50 per share to £40 per share. You decide to close your short position. You use £4,000 (£40 × 100)generated from selling the borrowed shares at £50, to repurchase 100 shares of Company XYZ at the lower price.

By returning the 100 shares to your broker, you’ve successfully covered your short position. The difference between the initial sale price of £50 per share and the repurchase price of £40 per share amounts to a profit of £1,000 (excluding any transaction costs or fees).

This example demonstrates how short selling allows traders to profit from a decline in a stock's price. However, it's important to remember that shorting stocks involves risks: if the stock price rises, you may have to buy it back at a higher price, resulting in a loss of capital.

Shorting is often regarded as being riskier than buying a stock: while a stock value cannot go below zero, there is no upper limit to the value it can reach, so there is potentially no limit to the amount of capital you could lose. Short selling therefore requires market knowledge, careful analysis, and the use of risk-management strategies.

How to short a stock: a step-by-step guide

Building on the basics of short selling, let's delve into the step-by-step process of how to short a stock.

1. Finding stocks to short sell

The first step is identifying stocks that you believe are potentially suitable for short selling. Companies that show evidence of one or more of the following characteristics may be susceptible to share price declines.

An outdated business model

Signs of being overvalued, particularly versus industry peers

A track record of being poorly managed

Weak fundamentals, for example a year-on-year decline in revenue and profit

Accounting irregularities or other controversies

It’s important to conduct thorough research, assess financial statements, and consider factors such as industry trends, the competitive landscape, and market sentiment.

You can also utilise various tools and resources to identify stocks that are heavily shorted. These include financial news websites, stock screeners that provide short interest data, and brokerage platforms that offer information on stocks with high short-interest ratios. These resources can help you identify potential candidates for short selling.

2. Opening a short trade: the process

Let’s say you had chosen to short BP shares thought trading CFDs. BP is trading at £40, which means that you could open a position to sell 100 share CFDs at £40, which would give you a market exposure of £4,000. With share CFDs there’s a commission charge to pay when you enter and exit a trade, which is 0.10% on UK shares, for example. Learn more about trading costs

As CFD trading is a leveraged product, you would only need to put up a deposit rather than the full value of the trade. So, with a typical margin of 20% for shares, your initial deposit to open the trade would be £800.

Winning scenario:

The market falls as you predicted, so you close your position by buying 100 shares at the new price buy price of £35. As a result, you make a profit, which is the difference between the opening and closing prices:

£40 - £35 = £5 × 100 shares = £500 profit (before commission charges are factored in)

Trading on leverage means that the CFD trade is calculated using the full value of your exposure, so your profits as well as losses are magnified.

Losing scenario:

Your prediction is proved to be incorrect, and the market increases in price, to £45. You buy 100 shares at the new market buy price to close your position. As a result, your trade results in a loss of £500, (£4,000 - £4,500 = £500 loss, before commission).

3. Managing risks in short selling

Short selling carries inherent risks and tends to be seen as higher risk than simply buying stocks. Here are some potential risk-management strategies to consider:

Set a stop-loss order:

A stop-loss order is an instruction to automatically close your short position if the stock's price reaches a certain level. This helps limit potential losses by exiting the trade if the stock's price moves against your prediction.

Practice position sizing:determine the appropriate size of your short position based on your risk tolerance and account size. Avoid taking excessively large positions that could expose you to significant losses. Remember that short selling is used for short-term speculation, therefore do not invest more than what you are willing to lose.

Stay informed

Monitor the stock's price movements, market conditions, and any relevant news or events that could impact the stock you’ve shorted. Look out for any potential catalysts that could cause the stock's price to rise, such as earnings announcements or regulatory changes. Be prepared to adjust your strategy or close your position if necessary.

Diversify your portfolio:

avoid concentrating all your short positions in a single stock or sector. Diversifying your portfolio helps spread the risk, and reduces the impact of any individual stock's performance on your overall portfolio.

Understand teh potential for short squeezes:

A short squeeze occurs when a heavily-shorted stock experiences a rapid increase in price, forcing short sellers to cover their positions by buying back shares, creating a snowball effect which drives the stock price up.

By implementing these risk-management strategies, you can mitigate the risks associated with short selling and help protect your capital, although these strategies do not remove the risks altogether.

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Advantages and disadvantages of shorting stocks

Short selling offers several advantages and disadvantages that traders should be aware of before engaging in the strategy.

Advantages of shorting selling

Profit from declining markets: shorting allows traders to profit from falling stock prices, providing an opportunity to generate returns even when the overall market is experiencing a downturn.
Hedging against long positions: short selling can act as a hedge against existing long positions in a portfolio. By shorting stocks, traders can offset potential losses in their long positions if the market turns bearish.

Disadvantages of shorting selling

Potential losses: Unlike buying stocks, where the maximum loss is limited to the amount invested, short selling carries the risk of unlimited losses. If a shorted stock's price rises significantly, losses can accumulate rapidly. With spread betting and CFD trading however, negative balance protection means losses are limited to the funds in your account.
Timing and market direction risks: Short selling requires accurate timing and market analysis. Predicting the timing and extent of a stock's decline can be challenging, and if the market moves against your short position, it could result in a substantial loss.
Borrowing costs and fees: When you borrow shares to short sell, you may incur borrowing costs and fees from your broker. These costs can eat into your potential profit and should be factored into your trading strategy.
Short squeezes: Short selling carries the risk of short squeezes, where a heavily shorted stock experiences a rapid price increase. This can force short sellers to cover their positions at higher prices, resulting in a significant loss.

It's important to weigh these advantages and disadvantages carefully, and consider your risk tolerance and trading goals before engaging in short selling.

You can spread bet and trade CFDs on a range of instruments with us, with flexible ways to trade on both rising and falling markets, including the ability to short sell stocks. This offers you the option to trade on potential short-selling opportunities.

Short selling Stocks FAQs

Can I short any stock I want?

Not all stocks are available for short selling. The availability of stocks for shorting depends on factors such as market liquidity, borrowing availability, and regulatory restrictions. Some stocks may have limited borrowing availability, or may be restricted from short selling altogether. It's important to check with your broker to determine which stocks are available for shorting.

How long can I hold a short position?

The duration of a short position is flexible and depends on your trading strategy. You can hold a short position for as long as you believe the stock's price will continue to decline, or until you decide to close the position. However, it's important to note that short positions may have borrowing costs, or other costs (such as holding costs for spread bets and CFDs) associated with them, so holding a short position for an extended period can increase these costs.

Is short selling suitable for long-term investors?

Short selling is typically not recommended for long-term investors who are focused on building wealth over an extended period. Short selling is a more speculative and short-term trading strategy that requires active monitoring and market analysis. Long-term investors generally aim to benefit from the overall growth of the market and prefer to hold an asset for longer periods.

Can short selling cause a stock market crash?

Short selling alone is unlikely to cause a stock market crash. While short selling can contribute to market volatility, it’s just one factor among many that influence market movements. Market crashes are typically the result of a combination of various factors, including economic conditions, investor sentiment, and systemic risks. Short selling can help to identify overvalued stocks, which can contribute to market stability in the long run.

How do I know if a stock is heavily shorted?

You can determine if a stock is heavily shorted by looking at its short interest ratio. The short interest ratio represents the number of shares sold short divided by the stock's average daily trading volume. A high short interest ratio indicates the percentage of a stock's float being held in short positions. Financial news websites, stock screeners, and brokerage platforms often provide this information for individual stocks.

*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.

*Tax treatment depends on your individual circumstances. Tax law can change or may differ in a jurisdiction other than the UK.

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