Explaining Short Selling
We have discussed an example of buying in a commodity such as oil. You can also sell (sell short) through spread betting. I found this a tricky subject when I first started out, and so I will try to explain it as simple as possible. You have to understand this concept before you can use spread betting to your best advantage, and many people tend to struggle with this.
Prices can go two ways, up and down. I have explained what to do if you think oil (say) is going up, but what if you think it is going down? You don’t have to gamble only on rising markets – you can make money (actually a great deal of money) on falling markets too.
David Jones of IG Index explains the workings of Short Selling
How do you achieve this?
Simple. You take an option to say, SELL oil in three month’s time. Let’s say the current price is $98 a barrel and the 3-month future price is $103. You think this is hogwash and the price is going to drop to less than $85 within three months. You sell March oil at $103. You pay a deposit to secure ‘your’ oil sale as you paid to secure your oil purchase.
How on earth can you sell oil you don’t have? Simple. Your sell order guarantees a buyer of ‘your’ oil in March at $103 – in effect, someone has contracted to buy your oil at $103 a barrel in March. This is someone betting against you, buying March oil at $103/barrel, just like you did in the first example. Come March, you MUST buy your oil at $103/barrel, or pay you the difference between the March price and $103.
If the price in March is only $85 a barrel (as you predicted) then you just buy oil at $85 a barrel (the current price) and sell it to the guy who contracted (unwisely) to buy it from you at $103! You pocket the $18 difference! Of course, no oil ever changes hands. This is just a paper exercise. Also, oil is just one of thousands of possible futures ‘plays’ you could make. There is nothing special about oil. I am just using this as an example.
Who is the ‘mug’ who contracted to buy from you at $103. Why, just another punter, like you buy who thought the opposite to you. He thought the price was going to $120 and then YOU were the ‘mug’ for contracting to sell him March oil at ‘just’ $103 a barrel. He was looking forward to scamming you out of your oil at the giveaway price of $103, and selling it immediately for $120 and pocketing the $15 difference. He could have been right, of course. In which case, he would have won, you would have lost. This is just 1 barrel of oil but imagine if you had to buy 1000 barrels at $103 and sell to him at $120, thus losing $17,000! Ouch!
More information about Short Selling on our Strategies Section.
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