While most traditional trading makes profits on a given stock or other security increasing in price, shorting stocks, also called “short selling”, is the strategy of generating profit on the decline in value of a given asset. Through leveraged trading, the trader hopes the stock will decrease in value, giving them the ability to purchase them back at a lower cost, generating profit.
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What is short selling?
To perform short selling, a trader can choose one of a few options. They can either borrow assets, or use alternative financial instruments like contracts for differences (CFDs) or futures. After all, making a profit on the shares you actually own losing value wouldn’t make much sense in most cases. In short selling, the trader speculates that the shares are going to fall in value, requiring a lower price to buy them back at a later time.
Leveraged trading often comes with interest and additional fees, so the profit must be large enough to cover those. Short selling presents incredible profit possibilities, but also introduces a high risk with very high loss potential. Shorting is an advanced trading technique and should only be performed by advanced investors who know what they are doing.
What’s the benefits?
If the speculation of the trader was wrong and the stocks increased in price, the costs could be high, reaching beyond 100% of the original investment. However, when speculated correctly, high profits can be achieved.
Leveraged investments are possible with short selling, making each trade very efficient for its price – you only have to pay a percentage of the deposit you would have to make in case of traditional trading. Each day, however, brings in additional interest and charge fees, which means trades should probably be finished as soon as possible to reduce costs.
If you’re interested in short selling in the UK, make sure to get familiar with the current FCA short selling regulations.
The potential risks
As with every financial instrument, short selling presents a range of risks, some of which might be bigger than in traditional investing. Massive short selling of a given stock can eventually drive the stock price to the ground, like what happened in 2021 with GameStop. In such cases, traders can get caught in a loop, with not enough shares available to buy when trying to close their positions.
With traditional investing, you can only reach 100% of the losses of your investment, since the value of a given stock cannot go below zero. However, in case of short selling, the costs are generated when the value rises – and there’s technically no limit to how high a stock’s value can go, creating potentially limitless losses. In the end, short selling offers traders and investors an alternative trading method with a high risk, but also high reward. The return of investment on successful short selling can go far beyond what traditional trading would offer, but the same goes for losses. Shorting requires a lot of experience and knowledge of the market, as well as constant research and vigilance. If you want to try your luck at shorting, don’t go all out at once – try to make it fit with your long-term investment strategy for security and lower portfolio volatility