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A complete guide to short selling

Published on: 08/10/2021 | Modified on: 20/09/2022

Most people understand the concept that traders make money through buying an asset and then selling it when its price goes up. However, it’s just as possible for them to make money when the value goes down. Traders can profit from declining individual share prices, volatile commodities or even an entire market crash by doing what is known as short selling. It's important for those who do it to understand fully how this type of trading works and the benefits and drawbacks. In this article, we explain how shorting a stock works, the potential implications for both traders and asset prices, and the factors traders look for that suggest an asset’s value is likely to go down.

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
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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 it work in trading?

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.

Use of leverage

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.

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Short selling examples

Shorting a stock

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.

Shorting an index

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.

Shorting a currency pair

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.

How to short a stock

  1. Choose your product. Decide whether you want to short stocks with our spread betting or CFD trading accounts. See the differences between CFDs and spread betting​ if you are not sure which to choose.
  2. Find the right stock to short. Make use of our news and analysis​ section to inform yourself of market turbulence that could precede stock crises. Also, our fundamental analysis resources could help you determine which companies are likely to struggle, such as our Morningstar equity reports and live Reuters news feed.
  3. Manage your risk. Before you place a trade, make sure you have adhered to a suitable risk management strategy. Read more on managing your risk​.
  4. Go ‘short’ and sell. Choose a position size in line with your trading strategy and place a ‘sell’ order ticket request for your chosen stock.
  5. Monitor your position. See whether your prediction was wrong or right and take the necessary steps afterwards to either buy back the shares at a higher or lower price, and profit from the difference.


Get started with by opening a live account. Our leveraged trading accounts are also available as a demo account in a risk-free environment for all customers, where you can practise trading with £10,000 of virtual funds.

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What are the costs associated?

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:

  • Commission charges. Share CFDs attract a commission charge every time you enter and exit a trade, which varies depending on the share’s country of origin.

  • Holding costs. These incur when holding a position overnight at the end of a day’s trading (5pm EST) and can be debited or credited according to the position you hold and the direction of the market.

  • Capital gains tax. This is only applicable to profits made on CFDs.

  • Additional spread charges. There's an additional spread on share spread bets when you enter and exit a trade, which is built into the prices displayed on our platform.

See our trading costs​ in further detail.

What are some of the most shorted stocks in recent years?

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:

Company name Industry Short percentage Date
GameStop [GME] Gaming retailer 114% January 2021
Sky Harbour Group [SKYH] Aircraft rental 49.9% April 2022
Weber [WEBR] Barbecue manufacturer 45.8% June 2022
Beyond Meat [BYND] Plant-based food 40.8% June 2022
Tesla [TSLA] Electric vehicles 28% September 2017

Data sourced from ORTEX. Please note that past performance is not a reliable indicator of future results.

What is a short interest ratio?

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.

How to find assets to short

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.

  • Technical analysis tools are useful in determining the general direction of an asset. These include trading indicators such as the simple moving average (SMA) or exponential moving average (EMA), which highlight both the direction and speed of trends.

  • When it comes to shorting stocks, fundamental analysis drivers can also be good indicators of investor confidence and therefore whether an asset is likely to lose value. Missed earning reports (company profits not meeting expectations) or wider declining industry trends can prompt traders to start shorting stocks and the share price falling away.

Conversely, too much good news can also have the same effect — if a company is overhyped, it can attract a disproportionately high demand for its shares, resulting in a meme stock​ that then ends up perceived as overvalued. In this scenario, too, traders may start to short and the bubble may burst, causing the share price to fall.

Benefits and drawbacks of short selling

Benefits

  • A trader’s ability to hedge their risk and mitigate any long position losses by holding two opposing positions at the same time. If you hold a long position in a company which has a long-term upward trajectory, but a short-term disruption makes its share price take a sudden, brief dip, you can simultaneously open a short position and benefit from that short-term share price drop.

  • Leveraged shorting enables traders to profit from declining share prices, or even an entire market crash. While the 2008 financial crisis lost a lot of people a lot of money, those who saw it coming and shorted accordingly made a fortune.

Drawbacks

  • This short-term strategy is notoriously risky, with potential for only limited profit, but infinite loss. For example, a short trader borrows a stock and sells it at a market value of £100. If the stock price then plummets, the trader has made a profit. But because the price can’t fall below zero, the maximum profit can only be £100 (the maximum possible difference between the original market value (£100) and the price to buy the stock back (£0).

  • However, if the trader has made the wrong call and the £100 stock rises, there is no ceiling on how high it might go — £1,000, £1m, £10m — meaning there’s no limit to how much the trader could lose. And the higher the price soars, the more desirable and scarcer the shares, so the more difficult and expensive it is for the trader to buy them back to return to the lender.

  • Leveraged traders, however, can manage this risk with the use of stop-loss orders, which can be used to predetermine the price at which you will exit your trade.

  • Short sellers also risk a short squeeze. This happens when a group of traders incorrectly short a stock and then rush to panic-buy it back, making the share price rocket. This makes the stock scarcer, making it harder for other short sellers to buy it back and potentially incurring significant losses.

  • Not all products are available for shorting due to a number of reasons. There may be restrictions imposed at the exchange level (after a stock has just had its IPO, for example), or there may be a lack of liquidity within the market. Some brokers will also restrict shorting on assets that have seen a significant drop or increase in price (such as the short-term ban imposed on meme stocks​ like AMC and GME).

Getting started in the financial markets

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.

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FAQs

Is short selling legal?

Short selling is legal, although it has its detractors. Many people are uncomfortable with the idea of profiting from company failure, others believe (with some justification) that it artificially lowers stock prices, and there are instances where short sellers have joined forces and are accused of manipulating the market. However, many analysts believe that short selling provides liquidity and price discovery to the market, making it more efficient.

What are some short selling regulations?

The EU Short Selling Regulation (SSR) is the framework that has governed short selling in the UK and EU since 2012. After the UK left the EU, it was converted into domestic law as the Short Selling (Amendment) (EU Exit) Regulations 2018. In the UK, the regulation allows the Financial Conduct Authority (FCA) to prohibit or restrict short selling if the price falls by a certain proportion deemed inappropriate, or to intervene if trading activity poses a threat to financial stability and market confidence­.

What is naked short selling?

Naked short selling is an illegal practice of short selling a tradable asset without first borrowing it or ensuring it can be borrowed; selling something you don’t have. If a naked short seller is then required to cover their position, they will fail to deliver. Advocates of naked short selling argue it benefits longer term share price increases; detractors say it is a form of market manipulation and artificially drives down share prices.


*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.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

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