If you were told that it is possible to profit from a stock that has a falling price, would that make sense to you? Although it does sound counterintuitive, it is possible to do so by a practice called “Short Selling”.

By using short selling, you will be able to take advantage of a stock that is falling in price, and help hedge against potential losses, when stock prices move against you.

What is Short Selling?

Short selling is a tactic used by traders where stocks are borrowed and then sold on the open market, and then bought back at a lower price. The goal of short selling is to profit from a falling stock price, by borrowing a share and selling it at a higher price, and then buying it back once the stock price has fallen.
The difference between the first sale price and the second purchase price is the profit you have made.

To illustrate this, let’s say you borrowed a stock that is worth $50 and then sold it on the market. The stock price then falls to $20 and you buy it back at this price. You return this $20 stock to the broker to repay your borrowings and the $30 leftover is your profit.

Benefits of Short Selling

  • You are able to profit when there is a bear market (falling prices)
  • You can use it to ‘hedge’ risks on your stock portfolio. In the event that the stock market drops, the losses from your portfolio can be partially offset by the ‘short’ trades in your portfolio.

Disadvantages of Short Selling

  1. Costs of Borrowing Stocks - It can be difficult to borrow stocks because of the high interest associated with borrowing them. The interest costs also eat into potential profits and can further increase your losses, making it undesirable to trade.
  2. Margin Interest - if you are trading with a margin account (for example with CFDs) then the interest charged on your trades can accumulate, and take up a portion of your potential profits.
  3. Losses can be limitless - Since there is theoretically no limit to how high a stock price can rise, your losses could be potentially infinite.

Is Short Selling Illegal?

In most countries short selling is legal, although highly regulated. During the 2007-2008 financial crisis, many countries placed a ban on short selling, however, these have since been lifted. In countries such as Australia, Canada, UK and the USA short selling is legal as long as the ‘short trade’ is backed by a physical asset. In other words, you must borrow a physical share to open a short trade.

There is a type of short-selling that is illegal, however, and it is referred to as ‘naked short-selling’. This is where a short trade is opened without holding ownership of any physical asset

Is Short Selling Unethical?

There is a misconception that individuals who undertake the practice of short-selling are unethical, and hell-bent on making profits at any costs. They have also been accused of wanting their target companies to fail.

However, the reality is that short-selling serves an important market function of providing liquidity to the buyers and sellers of stocks, as well as preventing stocks from becoming overvalued.

Ways To Short Sell

Through lending shares from broker
As mentioned earlier, one way to short-sell a stock is through a broker. They will loan you the stock so that you can open the trade by selling it at the prevailing market rate, and then close the trade by buying back the stock to return to the broker.

By CFD trading
Another way to take advantage of falling stock prices, is through CFD trading. CFDs (Contracts For Difference) are a type of financial instrument that derives its price from another asset, such as stocks.

By short-selling a CFD you can capitalise on falling stock prices, without having to borrow the physical asset (in this case, stocks).
A well-known CFD trading platform that allows you to short sell CFDs is CMC Markets.

Short selling is an effective way to take advantage of falling stock prices, and also a good risk management tool for your stock portfolio. However, there are risks associated with short-selling with CFD trading, and stocks in general, so be sure to seek professional advice before attempting any trade.

Author's Bio: 

Misty Jhones