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Short Selling

What is it - How it works

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Page Summary:
This guide looks at what short selling is, how to understand it, and how to use it to generate profits from falling prices.
Note : Although this guide is on the Spread Betting part of the website Short Selling follows the same principles for all the markets, whether CFDs, Options, Stocks or Futures etc.

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.

How Short Selling works
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.

So forget about the markets for a moment and let's look to Cricket to help understand the concept of short selling.

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

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 people are introduced to short selling many ask this question -

'how can you sell something you don't own'

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, Pork Bellies or the FTSE 100 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 spread bet market for the FTSE is 4230 - 4232
  • You are bearish of the stockmarket expecting prices to decline
  • So you short sell £2 of the FTSE at 4230
  • See below for the possible outcomes
Three possible outcomes to this short trade example

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
Graphical representation of a short trade's profit & loss

The diagram visually shows how a short trade makes and loses money. The position is short a share at 10.

Short selling might seem somewhat complex to understand at first sight but give it some time and it will sink in and become second nature.

Finally, the concept of short selling is the same for any product whether that be the FTSE, Gold, Pork Bellies or Cricket.

WARNING! - Spread Bet Broker Advice

There are good spread bet brokers and there are bad ones.

Having a good broker won't guarantee you profits but a bad broker will probably lead to losses as a combination of their gamesmanship and suspect software takes its financial toll.

So who do I recommend?

Simple, the 2 brokers I personally use for my own spread betting (and I've used them for years) -

FREE Report : How to Learn Spread Betting and Prosper
How to build the all-important trading experience
Where to get trading help and advice
Which broker to use and why
Simple 2 month training plan to follow
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