This article is going to discuss the concept of short selling, a technique used in trading to profit from declining prices. Although the idea of selling an instrument without having it actually bought before is not a complex one, a lot of investors have trouble understanding it, as they would usually buy first, wait a while for the appreciation and then sell in order to make profit. However, selling first without owning a particular stock allows the interested party to profit from declining markets.
As spread betting allows you to take position in almost any market it also allows you to bet on any directions those markets may be moving, meaning that as much as you can profit from rising prises by going long, you can also increase the value of your portfolio in bear market by going short. So if you think a particular company is not doing very well and are convinced that in the foreseeable future its price is going to go down, you may actually sell the stock, i. e. go short on that one, wait for the price to decline and buy it back later at lower level, pocketing the difference.
Let’s say that the value of the company in question is £112 per share at the moment. At the same time you forecast that due to the current market turmoil and situation in the sector the company is not going to deliver and the equity price is going to fall. After assessing your risks you think that odds are in your favour and you decide to sell at £112. Now you have an open short position and wait for the price to fall, so you can buy the share back later to close it with profit.
Let’s say you were right and the price falls and it goes as low as £73. You now think that this is it and the value will not fall any further, so you decide to close out the position by buying the share at £73. As your proceeds from the sell were £112 and your expenses were £73 per share (the amount you needed to buy it), the difference between those two figures would make what you can call your profit, i. e. £39 per share.
Let’s look at a different scenario now. Assuming you sold the share at £112 in the hope the market would fall you watch now the development in the share movement and you see that the company was actually able to turn around and is actually making better than you predicted and the price is starting to go up and you see it is at £130 now. If you were to close out the position you would have made a loss of £18 per share. However, if you waited and saw the price raising even higher to £153 or £214 your losses would be even bigger.
In fact, while the potential profits are limited (the lowest a share can fall is 0), there is no upside cap on the price of a share, hence the potential losses arising from such a trade could be unlimited making short selling a very risky strategy.