Short selling is the action of taking a position on a stock – or other asset – that earns a profit if it falls in price. It’s the opposite of ‘buy low, sell high’. Learn how to short stocks, forex, indices and more here.
- What is short selling?
- How does short selling work?
- What does short selling a stock mean?
- Short selling example
- How to short sell a stock
- When should you short a stock?
- The risks of short selling
- Example of a short squeeze: hedge funds vs GameStop
- Short selling summed up
- Short selling FAQs
What is short selling?
Short selling is the common practice of opening a position in the expectation that a market is going to decline in value. Shorting is often associated with stocks, but you can short sell a range of assets – including forex, indices, commodities and interest rates.
In traditional investing, you take long positions, believing that your market is going to rise in price. Later, you’d close your position by selling the asset on and taking any profit. When you short sell, you’re taking the position that the market is going to fall in value. Later, you’d close your position by buying the asset back for a lower value and taking the difference as profit.
If the asset rises in value instead, then you may have to buy it back for more than you sold it for, meaning you earn a loss.
Shorting is most commonly used as a means of speculating on market prices, enabling you to take advantage of bear markets and short-term declines. It can also be used to hedge against the downside risk to a position you currently have.
How does short selling work?
Short selling typically works by borrowing an asset and immediately selling it on at the current market price. Then, if that asset goes down in price, you can buy it back for a discount, give it back to the party that lent it to you and pocket the difference as profit.
Or at least, that’s how traditional short selling works. But thanks to the rise in derivatives trading, it’s no longer the most common way to take a sell position.
- CFDs are contracts in which you agree to exchange the difference in an asset’s price from when you open your position to when you close it. You can use them to go long or short
- Options give you the right, but not the obligation, to buy or sell a market at a set price. You can buy put options or sell call options to get a short position
To see the difference between them, let’s examine a market that’s popular among short sellers: stocks.
What does shorting a stock mean?
Shorting a stock means opening a shares position that earns a profit if the company you’re trading falls in value. Typically, this involves borrowing shares that you don’t own and selling them to another investor. The aim is to buy the shares back later and return them to your lender, pocketing the price difference.
But as we’ve seen, there are other ways to short a stock too. Here’s an example of each one.
Learn how the stock market works.
Example of shorting a stock
Let’s say you thought shares of Company XYZ were going to fall from their current price of £50 per share – so you want to open a short position. You can choose traditional short selling, CFDs or options.
1. Traditional short selling
You contact your broker and borrow 10 XYZ shares, then sell them immediately for £500.
Your prediction is correct and XYZ stock falls in value, down to £30 per share. So, you close your position by buying back the shares at the new price of £300. You’d return the 10 shares of XYZ to your broker and pocket the £200 difference yourself.
What if your prediction is wrong? If XYZ rises to £60, then you might have to buy your shares back for £10 more than you sold them for – earning you a £100 loss.
Finding a broker willing to lend you stocks to short can be difficult, as they’re essentially taking on the risk that you’ll be correct and return their shares at a much lower value. This is why most brokers will charge you interest for as long as your position is open.
2. Short selling with CFDs
What if you decided to short Company XYZ with CFDs instead? Here, you would trade 10 XYZ CFDs at £50, not the underlying stock. And instead of borrowing the stock and selling it on, you simply choose to ‘sell’ your CFDs rather than buying them.
This means that you pocket any negative price action in XYZ as profit and pay any positive movement as loss. If XYZ falls to £30, you can close your position by buying your 10 CFDs and earn a £200 profit (as 30 - 50 x 10 = £200). If XYZ rises to £60 instead, you make a £100 loss.
As you can see, when you short sell with CFDs, you won’t need to borrow the shares before you take your position, as you’re just speculating on the underlying market price. You’d just need an account with a derivatives provider, and you could open a short position simply by selecting ‘sell’ in the platform.
3. Short selling with options
The final way to short a stock that we’re going to cover here is by using options: derivatives that give you the right, but not the obligation, to buy or sell a stock at a set price. There are two types of options: calls give you the right to buy, while puts give you the right to sell. The most common method of short selling with options is using puts.
You could, for instance, buy a put option that gives you the right to sell 10 shares of Company XYZ at £45. Then, if it drops to £30, you keep the (10 shares x £15) £150 as profit. If it rises to £60 instead, you only lose the premium you originally paid for the option.
Learn more about how options work.
How to short sell a stock
To start shorting stocks and more via CFDs, follow these steps:
- Open your City Index account and deposit some funds
- Choose a stock to sell using technical or fundamental analysis tools
- Open a position to ‘sell’ the stock, and choose how many contracts to sell
- Monitor the market, and close your position by selling the CFDs
If your initial prediction was correct and the stock fell in value, you could close your position and profit from the difference between your sell and buy prices. But, if the market increases instead, you might have to close your position at the new higher price – ultimately generating a loss.
To practise short selling with zero risk, try opening a free trading demo.
When should you short a stock?
Typically, you’d short a stock if you have a bearish position on the future of the company – either in the short term or over a longer timeframe. There can be lots of different reasons why you think a company is set for a fall: you might believe that a stock market crash is on the cards, for example, or think that the business is poorly managed.
However, there are two general reasons to go short: speculation and hedging.
Speculators want to make a profit from an asset’s fall in price. This can seem like a negative practice, but short sellers are an important part of the market ecosystem, taking the other side of trades to provide liquidity.
For traders, shorting provides a whole extra dimension to the markets – doubling the number of opportunities at any given time. Some trading styles, such as swing trading, are even built entirely out of the ability to buy when times are good and sell when they aren’t.
The other main reason to go short is as a hedge.
Say you own 500 Tesco shares, but you’re worried about a short-term fall in the stock. You think it will pick up again, so you don’t want to sell your portfolio, but you would like some insurance in case it loses you money.
You could use CFDs to short Tesco, giving you a position that earns a profit if it falls in price, offsetting the loss in your portfolio. Or you could use options to guarantee a sale price. Here, both short trades are intended as a hedge instead of speculation.
The risks of short selling
Potentially unlimited risk
Trading against the trend
Short selling is riskier than traditional long positions, as there’s theoretically an unlimited upside for a market. If your prediction is wrong, you could incur infinite losses. This makes risk management a crucial part of preparing for a short position. With us, you can attach a guaranteed stop to your position to make sure your position closes automatically at a level of loss you’re comfortable with.
Stock markets tend to go up in value overall – as a glance at a long-term S&P 500 or DAX chart will tell you. So, by shorting shares, you might be going against the prevailing market trend. This can see short-term profits, but earning a return over the long term by shorting could be tricky.
Plus, markets can remain irrational for longer than you might think. Just because a correction looks due, doesn’t mean it will actually arrive in the coming weeks or even months.
When you short sell, you’re borrowing stock – or in the case of CFDs, borrowing capital to fund your leverage. Because of this, you’ll typically pay interest on your position over time, which can eat into your profits or worsen your losses.
Another risk is that a short squeeze occurs, which happens when the market rallies and short-sellers need to exit their positions quickly. Squeezes are a chain reaction, so as more short positions are closed, the price is driven higher, causing even more traders to sell.
Learn more about what short squeezes are.
Example of a short squeeze: hedge funds vs GameStop
Hedge funds are the most notorious short-sellers, as they frequently use short positions to hedge their long positions on other stocks. But it’s always worth noting that even such active shorters aren’t immune to the risks of short selling.
For example, in January 2021, institutional investors – including the hedge fund Melvin Capital – saw an opportunity to go short on GameStop’s falling price. The gaming firm had experienced a few years of declining revenues and forced store closures, which made short selling the stock seem like a sure thing.
However, huge numbers of amateur investors decided to buy GameStop shares – or rather stock options – to send a message to Wall Street short-sellers that profiting from the company’s troubles was wrong. Several Reddit users asked people to push the price up and create a short squeeze. The sheer volume of buyers caused a huge rise in GameStop’s share price and massive losses for the hedge funds involved.
The hedge funds and investors that were short on the company were forced to find buyers to stop their losses from rising any further. This created additional demand and pushed the price up even further.
Short selling summed up
- Short selling enables you to take a position that an asset is going to fall in value
- The practice of shorting is often used for stock trading but can be used for other assets such as currencies, commodities and indices
- Traditional stock short selling involves borrowing the asset from a broker, selling it on the market, and buying it back at a lower value – profiting from the difference in price
- Short selling with derivatives, such as C, means you don’t have to borrow the shares. You’ll have the option to short sell any market by clicking ‘sell’ on the platform
- Short selling comes with risks, such as infinite losses and short squeezes
- It’s important to manage your short-selling risk with stop-loss orders
Short selling FAQs
How long can you short a stock?
It depends on your chosen method of going short.
In theory, you can short a stock indefinitely using traditional short selling or CFDs. However, with the traditional method you may find that your broker has limits on how long you can borrow stock for, and with both methods you’ll have to pay interest.
Options are time limited – you’ll need to close your position (or leave it to expire and lose your premium) during the option’s term.
Is short and sell the same?
Yes, you can use the terms short and sell to mean the same thing – taking a position on a market that earns a profit if it falls in value. Though selling also means closing a long position.
How much money do I need to short a stock?
With CFDs, you need the same level of funds in your account to short a stock as you need to go long – enough to cover the margin of the position, plus commission and any overnight financing. For instance, for our Company XYZ trade above you might need to have:
- 20% of the position’s full size, or £100, as margin
- £10 commission
- 2.5% - SONIA each day for overnight financing
Learn more about the costs of CFD trading.
What is the advantage of shorting?
The main advantage to shorting is that you can earn a profit when markets are falling as well as rising, or reduce the risk from long positions by hedging.
Take a look at any market’s chart, and chances are you’ll see a fair amount of downward price action, even if the overall trend is up. Without shorting, you’d look to avoid the markets during these bear runs – they can only earn you a loss. But by short selling, you can trade in any market conditions.
Find stocks to short with a City Index trading demo.
What platforms can I use to short a stock?
Learn more about our trading platforms.