Financial Analysis

What is short selling a stock?

Short selling, or shorting, is a strategy used by traders in an attempt to profit from falls in the price of a stock. While you can short other assets types, such as FX, commodities, or indices, stocks are the most commonly shorted instrument.

How short selling works

Traditionally, a trader interested in shorting a stock in a company needs to borrow them from someone who already holds them, like a broker. They then sell these shares at the going market price.

If their prediction is correct, and the shares in question do appreciate in value, they are able to repurchase the same quantity of shares that they borrowed for a lower price than they received when they first sold them. They can return the shares to the broker and keep the difference between the original sale price and the repurchase price – minus fees – as profit.

For example, imagine a trader interested in short selling Goldman Sachs borrowed 100 shares on June 5th, 2020, and sold them for $22,200 ($222.00 per share). They then waited until June 26th and bought 100 shares in Goldman Sachs for $19,000 ($190.00 per share). Without fees, they would have made a profit of $3,200.

A candlestick price chart illustrating short selling Goldman Sachs

Thanks to contracts for difference (CFDs), you don’t actually need to borrow or sell a stock in order to short it. You can simply short the CFDs, which are derivatives that track the price of the underlying stock, instead.

Why trade stocks short?

Shorting a stock gives you even more flexibility in how you trade the markets. There are many opportunities that you can take advantage of, as not every business has promising fundamentals or operates in a strong sector.

Wirecard is a perfect example. Although it was considered one of Germany’s leading tech companies, many, including journalists at the Financial Times, raised alarm bells. Wirecard was accused of misreporting its financials, giving the market a false impression of its business.

In June 2020 short sellers were vindicated, when, after having delayed reporting its results as many times as the regulators would permit, Wirecard was forced to admit that nearly €2 billion in cash that was missing from its balance sheet probably did not exist.

The share price collapsed. In the two days following the company’s bid for insolvency, the share price fell almost 100%, and short sellers made a total of $1.2 billion in the week ending June 26th.

Short selling isn’t always a sign traders believe that a business is poorly run or hiding potentially criminal activities. Sometimes they just believe that the market has made an error in how it is valuing the company, and that eventually the price will correct lower to reflect its fair valuation. Or they could be expecting that a wider market downturn will impact the stock in question more than others.

What is a short squeeze?

Short positions lose money when the asset in question rises in price. If something happens to drive an stock significantly higher, short traders may be forced to close their positions to prevent further losses. In order to close a short position, a trader needs to buy the stock that they are shorting. This increases the demand for the stock and pushes the price higher still. More and more short sellers are forced to close their positions because of rising prices, which in turn pushes prices higher and forces out more short sellers.

This is known as a short squeeze.

Using risk management when short selling

Just like with a long position, you can use risk management to lock in profits or limit losses when trading short.

Risk management on a short position works the opposite way around to a long position. So where a stop loss order on a long position would be placed below the entry level of the trade, on a short position your stop loss would be placed above it.

Similarly, your take profit level would be at a lower price than your entry price.

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