Short selling is a trading strategy that aims to profit on an anticipated decline in the price of a stock or share. Essentially, a short seller is seeking to sell high and buy low.
You're an experienced trader who knows how to find shares set to rise - and how to profit from them. But how can you profit when you think that a share price is going to fall? With short selling. Short selling turns around the old adage 'Buy low, sell high', enabling you to 'Sell high, buy low'. You start by selling a share you donít yet own, before buying it back later on. If the share price falls between the two trades, you keep the difference, less fees and brokerage.
As an example of how contracts for difference, or CFDs, have transformed trading, you need look no further than considering the advantages of short selling using CFDs rather than the actual shares. Short selling is a way for speculators to benefit from a decline in a share's price and you can now short thousands of companies' shares using CFDs, and gain all the advantages that the leverage can give you.
CFDs are ideal when you want to profit from a fall in price or a specific company decline. Any time you trade with CFDs you enjoy leverage of your money, which typically may be 10:1. This means that you can control ten times as many shares as you could afford with your initial investment. Aside from the trading costs, you are effectively borrowing money on margin, so you are charged a daily interest while you hold your long position. If you take on a short position, however, your account will be credited each day with a small amount of interest, which is just a modest bonus.
Short selling involves a three-step process. Firstly, you will need to borrow shares of the company you wish to short; typically you do this from your CFD provider or broker. Secondly, you sell the shares on the stock market at the market price. Lastly, you re-buy the shares (hopefully at a lower price) and return them to whoever you borrowed them from. The end of this arrangement will see you pocketing the difference if the share price has fallen, but will have lost money if the price went up.
In early 2008, XYZ shares (example only) were falling back from record highs. Julie decided that they were likely to fall further. So she used short selling to benefit from her view.
How she did it
On 10 Jan 2008, Julie placed a short for 15,000 XYZ shares at $6.28 per share. This means she sold shares that she did not own. To allow this, she must have borrowed the shares from someone else (her broker would have organised this for her).
On 7 Feb 2008, Julie closed her short position, buying back 15,000 XYZ shares for $5.47 each. After fees and brokerage, Julie earned a net profit of $11,881.98
Here are the transactions that would have occured in this example:
If the trader bought the shares back at a higher price, it would cost more than the initial sale and the trade would have resulted in a loss.
There is much more to short selling that you should understand.
This example is hypothetical and for illustrative purposes only. Past performance is not indicative of future performance. Short selling involves different risks to those affecting normal share investing.
You must also bear in mind the settlement date of these trades. ASX currently schedules settlement for all trades on the third business day following the date the transaction was reported to the market unless the transaction is classed as "deferred delivery or deferred settlement" (in which case the trade(s) must be settled on the date specified by ASX). Settlements which are not met on the scheduled date incur fail fees. To avoid incurring fail fees you must either buy the shares to cover the short position on the day the short position is created or have borrowing arrangements in place with your executing broker to cover the settlement on the third business day.
Another consideration is the margin cover. Margin cover is a requirement of the ASX Market Rules and may be in cash or Cash Market Products. If your broker permits short selling, they must obtain a margin cover of 20% of the value of the trade before placing your short sale order. Whenever the market price of your short sold security rises in excess of 10% of the contract price you must provide additional margin cover of 100% to your broker.
As an example, if you short sell 1,000 BHP at $16.00, the total trade value is 1,000x16, or $16,000. You must provide your broker with margin cover of 20% of $16,000, i.e. $3,200.
If the price of BHP rises by 15% while you are short sold, you are required to provide additional margin cover of 100%. That is, if the price increases by $2.40, you must provide your broker with additional margin cover of $2,400 (100% of $2.40 price rise x 1,000 shares).
One way to picking shorting candidates is to seek companies that have just released a disappointing trading update or profit warning. Such stocks are likely to experience a steep fall in their stock price on the day of the announcement but will likely recover some ground in the couple of days that follow. You can use this so-called 'dead cat bounce' as a shorting opportunity as the profit warning is likely to be following by broker downgrades which will place further pressure on the stock price.
Another way of researching suitable shorting candidates is to look for stocks that have recently had a very strong rally and could be susceptible to some profit taking; ideally here you are looking for shares that have been overbought and may have already started to fall. In such instances, you are taking advantage of short-term price retracements and hence the trades need to be planned on a short-term timescale. A suitable way to screen for these sort of opportunities is to use the relative strength index (RSI) indicator, however you also have to take into account other variables in the equation... For instance is the company a bid target? Is the stock approaching its yearly highs? In both scenarios shorting such stocks would be best avoided as the shares could still continue going higher.
Traditionally, when you thought that a share price was overvalued, and was going to fall, you could short the stock to achieve a profit. Shorting a stock, as you may know, is selling the stock first in the hope that the price will drop, and you will be able to close the position by buying the stocks at a lower level and replacing them. The mechanics are handled by your broker, and effectively you are borrowing the shares from somebody else while the position is open.
Now short selling using CFDs is much more simpler, and it comes with the advantage that you do not need so much money to take part in the gains from the shares fall in value. Take as an example the Royal Bank of Scotland, trading at 47.08 pence on Friday 24th October 2009. If you thought that this was going to fall, you could have placed a sell order for 20,000 shares, taking the short position. The total value of the contract would be £9,416. Typically you would only have to make a 10% deposit, so your initial margin would be £941.
By the 3rd November, the Royal Bank of Scotland was trading at 35.93 pence, and you decide to close your short position and take your profits. You would buy 20,000 RBS CFDs to close out the trade, and that would give you a profit of 11.15 pence per share. The profit on your trade would be £2,230.
To figure out the net profit, you would need to take in to account commissions and financing charges. Typical commissions would be about 0.2% of the share prices, so entering the position would have cost £18.83, and exiting £14.37. As you were short on the position, the financing charge is actually a credit, which would be around £5 in this case, depending on your CFD dealer.
Your net profit on the trade would be £2,201.80 (£2,230-£18.83-£14.37+£5), which amounts to 134% profit on your initial deposit. While a share trader would also have enjoyed a good profit from this short play, by using CFDs you have multiplied the returns significantly.
Short selling must take place in accordance with the exchange rules for the listed stock. For instance ASX Market rules have certain restrictions on shorting. Short selling is not permitted if:
Those restrictions wouldn't be applicable to stocks listed in the UK for instance since different rules apply there.