Short selling – be in the know

Short selling is an increasingly popular investment strategy in which an investor sells a stock only to buy it back in the future, at a lower price. The basic idea is to sell high and buy low. A popular way of conducting these trades is to use a Contract for Difference (CFD) via a site like Plus500, as you can go on to buy and sell units of stock without owning the underlying asset. This then creates a little more freedom for traders, allowing them to further manage risk in their portfolio and give the chance to take a more strategic approach to short selling.

And if that’s piqued your interest, then read on as we give you a beginner’s guide to the what, how and why of short selling.

What?

Short selling, otherwise known as shorting, regularly involves selling and trading in borrowed stock. The best way to do this is to work alongside a broker, who will take on the task of searching for the best price to sell your stock on your behalf, at the current value of the security. Then, when the price eventually declines, they will buy that stock back and return it to you, the lender.

Using this trading strategy can sometimes be risky, as you’re speculating on the stock’s decline.

How?

As we touched on above, short sellers are effectively betting that the stock they have just sold will drop in price. If the stock behaves as they were expecting, then the short seller will buy the stock back at a lower price. The difference between the initial buying price and the re-sell price is the profit that you will make.

This process of buying back your previous stock once the price has declines is referred to as covering your short, as you will be able to then return the borrowed stock and keep whatever money is left over in the difference. This, in turn, will protect you from any potential losses and allow you to make a quick short-term profit. The main reason for trading this way is to capitalise on a declining stock, however you’ll find that banks and hedgers choose to go short in order to protect their gains or further minimise their losses.

Why?

One sure-fire benefit of using the short selling strategy is the chance to walk away with a considerable profit. If your speculations ring true then you have the potential to earn a tidy sum, should the stock decrease as you’ve predicted.

With this, your investment is somewhat protected. The most that you stand to lose when using this strategy is the amount you have sold it for, as long as the price goes on to decrease in value, as you expect it to.

Due to the undeniable risks, shorting stock is best suited to more advanced traders. There’s really no way to know for sure how a stock’s value will evolve, there’s no real limit to the amount that an investor can lose betting this way, as a stock can just continue fluctuate in value. You should trade cautiously with this method, as there have even been cases where investors have ended up owing money back to their brokerage through short selling a stock that just continues to increase, instead of decreasing.

There are also a considerable amount of costs and fees involved when short selling, which are not included in the traditional long-form investment strategies. This aspect of the approach can outweigh the benefits, depending on your budget.

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Like any new approach to trading, you must make sure to conduct as much market research as possible, and seek advice from already established brokers, before you jump into a new way to invest.