A: Whilst the stock markets tend to rise over time, there are often short periods of turmoil when individual stocks, currencies or stock markets as a whole, decline in value. For instance, the tech-bubble burst in 2000, Sterling's collapse from €1.52 and $2.11 in 2007 and the more recent October 2008 credit crunch induced Dow Jones collapse, started by the banking sector. Buy and hold investing aims at profiting from a rising asset price (also known as 'going long') and then selling when you believe the stock price to be overvalued. You would then for the stock price to fall back to present you with another buying opportunity. In the past, it has been difficult for retail investors who have perceived a weakness in a market, or company, to take advantage of the anticipated fall.
Have you ever been absolutely sure that a stock was going to decline and wanted to profit from its unfortunate demise? And wouldn't it be nice to see your portfolio increase in value during a bear market? Well, short selling empowers you to do so!
The method of profiting from a falling share price or market is known as 'shorting', 'going short' or 'short selling'. Short selling is a trading strategy allowing you to make money on a decline in a financial instrument. Selling short is basically opening a position with a sale rather than with a purchase (going long). Short-selling is when an investor believes that the price of an asset, such as stocks, currencies oil or gold contracts, is going to fall, and agrees to sell that asset in the relevant market at a certain price - without having actually purchased the asset. The arrangement will need another party, who believes that the price of the asset is going to rise, to purchase the shares or currency. Although this may sound counter-intuitive, in reality shorting is just the opposite of investing in a market that is expected to rise.
So short selling involves selling shares that, essentially, you do not own. This is when a trader borrows shares from a broker and sells them, hoping the share price will fall. They buy the shares back at a lower price before they have to be returned, crystallising a profit. Brokers charge a fee for lending out the shares. There are two types of short selling: naked and covered. Covered selling being the more common approach involves borrowing the shares from someone who already owns the shares as we have already seen above.
There are two situations; covered, where you own the shares already and naked or uncovered, where you do not own the shares already (much more risky).
A: Imagine being able to sell something you do not own and being able to buy it back at a cheaper price sometime in the future. Just think if you could sell your car to your neighbour for $6000 while you were overseas for 4 months and then being able to buy it back off him when you returned for $5000. A cool $1000 gain and you still retain the car! This is essentially short selling and shorting using CFDs is now a widely used technique to profit from a falling market,
Think of short selling in this way: If you buy something and then you sell it you realise a gain if you sell it for more than you paid for it and a loss if you sell it for less than you paid for it. If you sell something and then you buy it back you realise a gain if you buy it back for less than you sold it for and you realize a loss if you buy it back for more than you sold it for. The idea that you first sell something and then you 'sell it back' doesn't work.
To Summarise -:
It is often said that stocks take the stairs on the way up...and the elevator on the way down. This is true - stocks tend to fall 3 times as fast as they rise as panic takes hold of investors.
A: 'Going Short' simply means opening of a short 'sell' CFD trading position to profit from a fall in prices.
Short CFD Trading Example: You saw that Game Group (LON:GMG) had breached a key support level and looked set for a pullback. You place a sell order for 40,000 GMG shares at the prevailing market price of 145p. The market value of the trade is $58,000 [1.45 x 40,000] and the margin rate on GMG is set at 15%. Thus, $8700 is required as Initial Margin collateral to open the trade. The trade is placed and you hold a short GMG CFD position with a market value of $58,000.
GMG issues a profit warning and in the next few days the price drops to 116p. Assuming that the position is closed at this price, the trading profit will be $11,600, which represents an excellent 133% return on investment.
However if the trade had gone against your position and you had decided to close the position when GMG was trading at 160p, you would have lost $6000.
Note that when opening a short position you receive a cash payment for the full market value of your short position and therefore receive interest on this amount at the LIBOR target rate minus 2.5% per annum (note: no daily interest is paid at the present time as interest rates are so low). The overnight interest rate is computed by dividing the per annum applicable interest rate payable by 365 (days per year).
Whilst short selling may have its roots much earlier, in its present form short selling has existed for around 400 years. The practice of short selling supposedly has its origin in the 17th century when a Dutch merchant named Isaac Le Maire invested 85,000 guilders in the Vereenigde Oostindische Compagnie becoming the largest shareholder in the process. Isaac never received any dividends and the ships were actually under constant threat in the Baltic from the English. Soon he fell into conflict with the VOC and he decided to sell his securities in the company. Further to this he founded a secret company with the purpose to trade in VOC shares. In fact, he was so convinced of Vereenigde Oostindische Compagnie's calamitous position, he ended up selling more securities than he had ever actually owned.
The earlier famous examples of short selling have typically presaged the end game of all the famous bubbles in the past few hundred years. These include the Dutch Tulip Mania of 1637 - 1638, the South Sea Bubble of 1773, and the Wall Street Crash of 1929. In fact, the first ban on shorting was by the Dutch in 1610 on the grounds that selling something you did not own was rather like bouncing a cheque. The next ban was in the UK in 1787 to protect banking stocks after a banking collapse. Perhaps the common link between previous down cycle is that bans tend to mark the beginning of the end of a down cycle, rather than the worst part.
The content of this site is copyright 2015 Contracts for Difference Ltd. Please contact us if you wish to reproduce any of it