| Spread betting is as much about flexibility as anything else. This means profits can be made from either rising prices or declining prices, so called short selling.
Understanding short selling is therefore critical. It is not difficult but I admit for some people it might take a few days for the process to sink in. You will know when you understand it as it's rather like riding a bike, you know if you can and you know if you can't.
Forget about the financial markets - Look at Cricket
One of the reasons why some people initially struggle to understand short selling is because it's the opposite way of how they've conducted business in the markets, ie they've only bought stocks etc. So forget about the markets for a moment and let's look to Cricket to help us.
England versus India
- You are watching a cricket match with a friend from India
- He states that he fancies his Indian compatriots to score at least 400 runs
- You disagree and so decide to have a bet
- You bet £20 on the fact that India won't make 400 runs during their innings
- Therefore if the Indians score 399 or under you'll win £20
- If India scores 401+ you'll lose £20
Adding more spice to the bet
But in the financial markets deals are rarely executed for a fixed wager so let's expand the bet -
- You and your friend both decide to have the same bet, you forecasting runs under 400, he forecasting more than 400
- Instead of the flat £20 wager you both bet £1 per run
- Your bet will therefore pay £1 for every run under 400 and lose £1 for every run over 400
- You have effectively sold Indian runs short at 400
Three possible outcomes for your short trade:
1. A Winning trade
- India score 325 runs
- 400 (the level at which you went short) - 325 (final score) = 75 runs
- 75 runs x £1 (per run) = £75 profit
2. A Losing Trade
- India score 450 runs
- 400 (the level at which you went short) - 450 (final score) = -50 runs
- -50 runs x £1 (per run) = -£50 loss
3. Breakeven Trade
- India score 400 runs
- 400 (the level at which you went short) - 400 (final score) = 0 runs
- 0 x £1 = no profit/loss
Now translate this cricket example into the stockmarket -
- Instead of selling cricket runs at 400, sell short the FTSE at 4200 at £1 a point
- If the market drops to 4150 you'll make 50 points x £1 per point or £50
- And if the market rallies to 4225 you will lose 25 x £1 a point or (£25)
But how can you sell something you don't own
As soon as most people are introduced to short selling the question 'how can you sell something you don't own' is asked. But how can you buy and sell cricket runs with your friend? You can't own runs, you can't touch them.
Remember, with spread bets you're trading a derivative, a market whose price is in turn based on another market's price. For example, when you spread bet Gold, Gilts or even the FTSE you're not buying or selling those physical products. If you make a profit in Gold you won't get paid in Gold, only cash.
So in reality spread bets are just numbers and if you buy the number and it goes up you'll make money and vice versa. Short selling is therefore nothing more than a bet that the number in question (perhaps FTSE, Wall Street or Gold) will fall in value.
A short sell example - The FTSE
- The market for the daily FTSE is 4230 - 4232
- You are bearish of the stockmarket expecting prices to decline
- So you short sell £2 of the FTSE at 4230
- The spread bet will make money if the FTSE declines and it will lose if the market rises
Three possible outcomes to the short trade
1. A Winning Trade - the FTSE drops to 4150
What is your profit?
- 4230 (initial short price) - 4150 (present price) = 80 points
- £2 (stake) x 80 points = Profit of £160
2. A Losing Trade - FTSE rises to 4300
What is your loss?
- 4230 (initial short price) - 4300 (present price) = -70 points
- £2 (stake) x -70 points = -£140 loss
3. A breakeven trade - FTSE at 4230
- 4230 - 4230 = zero points
- £2 (stake) x 0 points = £0
Short Selling Profit & Loss
The diagram above visually shows how a short trade makes and loses money. The position is short a stock at 10.
|
Stockmarket/Trading Providers
|
|
|
|
|
|
