CFD Trade: Going Short and Making a Profit

CFDs allow you to profit from a fall in the price of a share or other market instrument. Even if in the early learning stages of your CFD trading experience you aren’t sure whether you will wish to trade on the short side, you should still dedicate some time learning what ‘shorting’ is about so that your market knowledge is more complete.

A lot of people misunderstand shorting. They think it’s something strange. The way I explain it is this: say you wanted to buy a second-hand BMW and I said: ‘Give me £20,000 and I’ll sell you one’. I don’t have the BMW but I might think ‘I can buy one of those for £18,000 round the corner because I think I spotted one like that’. So I’ve shorted you a BMW. Effectively shorting stock is the same thing. You want to make money out of the stock moving down, so you short it first. At some point in the not too distant future you’re likely to buy that back.

One of the key advantages CFD trading; which is a leveraged based way of trading – is that it empowers you to place a trade whereby you can speculate that the market is going to depreciate in value. You see trading covers not only profiting when prices go up, but also when values fall. When you buy to profit from rising prices it is called going long. The way that you can profit on falling prices is called ‘going short’ or ‘short selling’, and although many people are worried about it when they first start trading, mastering going short is one of the keys to making a profit in good or bad markets. Trading the short side in practice means that you have opened your CFD trade using a sell order or ‘gone short’ to profit from a share price decline. You can go short on stocks, and you can also go short with CFDs. Going short is as easy as going long and although opening a CFD trade using a sell order might sound odds, it’s simply the equivalent of closing out your exposure to the market. You might look to sell short if a share is falling or you think that it is overvalued or you are expecting a profits warning.

When you trade with CFDs, you put up a percentage of the value of the underlying security, and this is called the margin. With stocks, it is often around 10%. Your account is charged each day you have an open CFD position, and you can think of this as interest for the virtual borrowing of the value of the holding. When you go short with CFDs, you still have to put up a margin, as this is security for the broker against you losing, but your account may be credited with daily interest while the position is open. This is because when opening a short positoin you receive a cash payment for the full value of your short position and receive interest on this amount at the RBA rate (in Australia) or Libor rate (in the UK) minus, say 2% per annum. The overnight interest rate is calculated by dividing the per annum applicable interest rate payable by 365 (days per year).

Going short is simply opening a short ‘sell’ CFD position to profit from a share price decline. Here you are anticipating prices to fall and will use a buy order to close your trade position. The obvious benefit of short trading is that you can profit directly from falling asset prices, which is very difficult to achieve without the use of derivative products such as CFDs. We’re all used to buying at £1 and selling at £1.50 – it’s just buying and selling in reverse.

One of the misunderstandings that a lot of traders have when they start trading CFDs is that there is a limited period of time you can stay short. That is not the case. There is a very remote possibility that the short stock that has been borrowed is recalled but this happens very rarely in practice.

What are the things to keep in mind when short-selling stocks?

Ignoring the obvious that you lose money when short positions rise in price but apart from that;

• short selling involves borrowing fees
• you pay out the dividend if you are short on the ex-div date
• forced buy ins can occur if there’s a limited amount of shares available for borrowing

In practice when evaluating a short-selling opportunity it is important to decide on a trade size, and suitable entry and exit targets. If you short-sell a company you also have to take into account any dividend payment that is paid to shareholders while you are short of the shares (since you will have to pay these from your account). Because of this it is pertinent that you check dividend dates so as to avoid liability.

My mentor used to always say bull markets don’t care about bad data until they start to care and then they start caring quickly.

Here’s an example of a short CFD trade -:

Suppose that you believe the price of shares in company AB, now at 125p, is going to fall following a lower than expected profit figures. You can open a short CFD position for, say, 10,000 shares (total market exposure 10,000 x 1.25 = £12,500), and that would require 10% of initial margin amounting to 10,000 x 125p, which is £1250. Commission might be 0.1% (of the value of the underlying shares) which would be £12.50. The total amount required to deposit with the broker to open the position would therefore be £1262.50. (initial margin + commission)

The rate of interest you receive is usually small, perhaps 2% less than the current bank rate. Say you held the position for 30 days, and the interest received was £24. You then close the position for profit, as the share price has dropped to 110p.

You have gained a gross 15p per share (125p open minus 110p close). That means that your 10,000 share trade has gained £1,500 gross. You close by buying back at 110p, which would cost £11 in commission. Your net profit from the transaction would be £1,500 less £23.50 (£12.50 + £11) total commissions plus £24 interest received, which makes £1,500.50

It is important to note that if the trade goes against you, your losses are similarly leveraged or multiplied, and it is possible to lose more than you initially staked.

* Financing is calculated at the average market price of 117p.

Short Selling’ or a ‘short position’ is placed if a trader believes the market price is set to fall. A trader sells the position first and then buys the position back at a later date to close out the trade. This is the opposite to a ‘long position’ or ‘going long’

Long/Short Strategy – Hedging

It is interesting to note that CFDs can also function as insurance (i.e.utilising CFDs as a hedge) rather than just as a means of highly geared speculation. In particular, you may wish to take up a short CFD in shares where you already hold physical long positions, but where you are bearish on the shares’ short-term prospects. In such circumstances, you may wish to avoid on outright sale of shares so as not to incur a CGT liability. The paper loss on the value of the shares is offset by the profit from the CFD trade if the CFD trade is closed out for a profit.

Short CFD Trading Example

Opening a Short (Sell) Trade: Profit

CFD traders usually earn interest on short positions although in practice this is dependent on the underlying currency interest rates. This is something to consider if you wish to hold a short position for the long term.

Example: Short position in Telstra Corporation (TLS).

On 24th June 2010 you believe TLS is in a market correction and take a short position in TLS share CFDs. You decide to place a 50c trailing stop loss.

Opening the position

Telstra Corporation is quoted by your CFD provider at $3.23 bid.

You sell 10,000 Telstra share CFDs at $3.23. The total contract value (i.e. position size) of the trade is: $3.23 x 10,000 = $32,300.

The margin required to open the trade is 10% of the total value of the position and is calculated as follows: $32,300 x 10% = $3,230. Remember if the share price moves against you, it is possible to lose more than this $3,230 initial margin.

In this example commission is charged at 10 basis points. One basis point is 0.01 of a percentage point. To determine how much commission you would pay, you multiply your position size by the commission charge. Here this is $32.30 ($32,300 x 0.10%).

Whilst short you will earn interest on the trade at a rate of 2.25% per day calculated as follows: $32,300 x 2.25% / 365 = $1.99 per day*.

*This will fluctuate according to the daily closing price of Telstra Corporation.

Closing the position

Telstra Corporation reaches lows of $2.11 in mid-August. A stop is then moved down 50c above this level at $2.61. On the 24th August Telstra’s share price reaches $2.01 and you decide to close the position.

You now buy 10,000 TLS share CFDs at $2.01. Profit is calculated as: ($3.23 – $2.01) x 10,000 = $12,200.

The commission charge of 10 basis points will also apply to the closure of the trade, equalling $20.1 (10,000 X 2.01 x 0.10%).

The position earns interest of $1.99 per day for two months: $1.99 x 60 days = $119.40 approximately.

You have also incurred opening and closing commissions of $32.30 and $20.1 respectively totalling $52.40

Your total profit on the trade after deducting the commission charges is: ($12,200 + $119.40) – $52.40 = $12,267 approximately*

* If the position had moved against you, you would have incurred a loss on the trade.

Conclusion

Although contracts for differences should not be regarded as substitutes for long term investment or saving, as more retail investors seek to take control of their financial destiny, there’s been a growing realisation that going short is a legitimate means of trading in a market that’s become increasingly difficult to profit from in a traditional sense.