Just like a trader can profit from the rising value of a stock, they can make gains from a fall in value too. The second trading strategy is called short selling or shorting a stock. Shorting a stock is the exact opposite of going long on it.
How to short a stock
When shorting a stock, the underlying security is not owned by a trader; it is borrowed. The trader’s brokerage lends the stock to them, which can be bought when the price falls back. Here’s an example.
Suppose a stock has a price of £100. You, as the trader, believe it is trading at a much higher valuation than it should. This leads to the expectation that the price will fall. You can decide to short this stock. You borrow ten shares from your brokerage, so your total borrowing is now £1,000, excluding any fees and interest charged.
If the stock’s price falls to £50, your total borrowing amount falls to £500. Now you can close your short position and buy back the ten shares. This will yield a profit of £500 for you.
With the basics of shorting a stock clear, the question now is choosing a good broker. An investment platform like CMC markets can be a good one to consider. Not only does it provide the option of shorting stocks, but you can also engage in spread betting and CFD trading.
Which stock to short?
The investment industry is vast, and research is constantly available for traders to benefit from. But they can be divided into three categories for convenience. The first and probably the most popular is fundamental analysis. This involves looking at the company’s financials.
A company growing fast and piling up profits will likely be an attractive investment. But that’s not all. Sometimes its price can rise so fast that. As a result, it gets far ahead of the prices of peer companies. This can be a case of shorting the stock.
Another example is a company’s earnings results. Typically, stock prices react to results. If the results are positive, it can rise the other way around. So, if a trader expects the results to be wrong, they can decide to short it since the price can fall after the announcement.
Often considered along with fundamental analysis is thematic research, the second category. It can happen that a stock is doing well, but a significant policy decision can affect it. An excellent recent example is windfall taxes on oil and gas companies.
These companies have profited significantly as energy prices rose fast in the past couple of years. But these profits can be affected if a tax is imposed. A trader can decide to short these stocks based on the expectation of falling profits.
A third way to consider which stock to short is technical analysis. This involves looking at the trends in stocks. A stock that drops below its 200-day moving average might continue to fall further.
So, it can be a good time to shorten it. The fundamental analysis can get far more complex, but the example still serves as a pointer for what you can look for.
Advantages and risks of short selling
With the investment environment constantly fluctuating, companies find it beneficial to hedge risks. This is where short selling comes in. Consider this example. You have bought shares of Apple for 15 years. But through this time, the stock markets can rise and fall due to many reasons.
These days the economy is a big concern. You might think that Apple’s shares will fall if a recession happens. So right now, you can short the stock to hedge your long-term bets. This will reduce your potential losses if the stock does fall.
Also, it allows for making profits even during difficult times. It is relatively straightforward to be able to profit from growth. But the opportunities can thin during times of weak stock markets. Short selling allows earning investment income even during such times.
But there are risks too. First, shorting stocks is typically for investors or traders with a fair bit of experience in the stock markets. This is because it requires knowledge of which stocks to short and which not to.
Also, there are limits to profits. A stock price cannot fall below zero. But it can rise endlessly. This means the losses can be unlimited.
Good choice for a bear market
A bear market, where investors are fearful, is unlikely to result in a broad rise in share prices. It can be a good idea at such times to short stocks and make profits from them. Forecasters predict that 2023 can be a bear market.
The critical takeaway is that this could be the right time to start if you would like to dabble in short selling.
Disclaimer:
Spread bets and CFDs are complex instruments with a high risk of losing money rapidly due to leverage. Most retail client accounts lose money when spread betting and trading CFDs.
It would be best to consider whether you understand how spread bets and CFDs work and whether you can afford to risk losing money.
Marketing for CFDs and spread betting is not intended for US citizens as prohibited under US regulation.