Explaining Short Selling

Pinpointing the right investment opportunity can be tricky and with the economy still in the doldrums fewer traders than ever are earning a decent return from stocks and shares. However, when the market is only rising sporadically, it is entirely possible to profit by spread betting on the downward movement instead. This is known as short selling or shorting.

Shorting is an option every trader should have in their repertoire and can also help to hedge against conventional bets or investments. It works in exactly the same way as spread betting on the price increasing, except that everything is reversed.

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.

How Short Selling Works

Making Money when the Price Drops!

To start with it can seem a bit strange to be rooting for something to drop in value, but you will soon get used to cheering for your stock to drop. Conversely, if you opt to short an investment, you absolutely don’t want to see the price rise. This is a very peculiar notion for most investors!

To benefit from short selling it is important to identify a target that is at the top of its price range, or even better, over-priced. Although your investments may have done very well at dropping in value in the past (when you didn’t want them to), finding a suitable subject for shorting is more difficult than it sounds. Simply considering the price is a dangerous strategy because there are many more variants that affect the market.

Shorting tends to be a relatively rapid type of trading, with positions usually opened and closed on the same day. It is also important to be able to move quickly because prices can take a dip even if good news is released, only to spring back higher. Companies that you believe may be about to issue a profit warning are worth considering as are those that are struggling to pay off their debts.

Companies operating in tough competitive markets tend to be a good place to start looking, as well as those in the world of technology. Rival firms are always releasing products that make existing goods defunct.

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.

Why are people afraid of Short Selling?

Losing isn’t Easy

Deciding to take a short position should never be a snap decision; it is necessary to conduct as much research and obtain background information in the same way as you would for betting on a stock to rise in value. Everything works in the same way; you simply have to invert the indicators.

Many people make the mistaken assumption that finding a market to go short on is simpler, but any losses can be substantial as there is no upper limit to how far the subject could rise. There can also be heavy swings and there tends to be greater volatility, all of which can sting the unprepared investor.

However, despite the risks associated with the practice, shorting undeniably offers a far wider range of opportunities, especially in a bear market or an economy that is struggling. There is nothing inherently ‘wrong’ about betting on a price dipping lower; markets are cyclical and there would be downward movements even if you did not place a bet.

Shorting on spread betting allows an investor to use their knowledge to profit from a market that is dropping in price in the same way as making money from one that is rising. Whichever way you opt to place your bet, it is essential to back your investment with solid research to give yourself the best chance of a good return.

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