What is short selling?

In stock market trading, as in all forms of trading, there are widespread investment techniques and methods that allow the implementation of precise and effective strategies. Among the most popular of these methods, short selling is worth knowing because it can be applied to many stock assets. Here are some explanations about this stock market investment technique.  

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What is short selling?

What is a short sale?

Short selling is a particular method of investing in the stock market. It is very different from the traditional investment method which consists of buying a stock to sell it later and making a capital gain if the price rises, and even works the other way round.

In summary, short selling can be described as selling securities before you own them. In this case, it is the intermediary or broker who borrows these securities in exchange for the payment of interest on behalf of the investor. For the investor, the method consists of waiting for a drop in the price of the borrowed assets in order to buy them back at a lower price and thus make a profit on the difference between the sale price and the purchase price.

 

What stocks can I sell short?

Short selling is one of the only methods of making a profit when a stock falls in value. Because they require speculating on the decline in value of a company, they are still prohibited today by some countries such as Greece and Venezuela. Some companies also prohibit the short sale of their securities. It is the case for example of the companies Michelin or Lagardère.

Fortunately, short selling is allowed in most European countries as well as in Japan and the United States. But in France, the securities that can be sold short from a traditional securities account are only those that are eligible for the SRD or Deferred Settlement Service.

 

The benefits of short selling :

In this period of economic crisis and while the financial markets are more often bearish than bullish, short selling is a method more and more appreciated by investors since it offers the possibility of profits despite bad market conditions. It is for this reason that certain laws aim to limit them.

This is the main advantage of this investment method, which allows you to take advantage of new opportunities during periods that are not conducive to the appreciation of stock market prices, as is currently the case.

These short sales can of course be used in addition to traditional investments, in particular to cover the risk of losses on certain assets.

 

Example of a short sale:

To better understand how a short sale works, here is a concrete example:

Let's say you decide to short sell 10 shares of company X for 35 euros each. At the end of the month, these shares are now worth 30 euros. You therefore decide to buy back these shares in order to profit from the price differential.

In this case, the capital gain is equivalent to the difference between the sale price and the repurchase price, multiplied by the number of shares concerned, i.e. :

Profit = (35-30)x10 = 50

Your gross profit is therefore 50€ on this operation. However, it is necessary of course to subtract from this result the amount of the interests of loan contracted near your intermediary or broker but also the amount of the dividends which will be paid directly to the short buyer.

 

When and why short selling?

There are many reasons why an investor or institutional investor might want to short sell. We will explain here when and why to use this strategy, especially with CFDs that allow short positions.

First of all, the most common reason for short selling is that it allows investors to have the opportunity to invest in the market even when it is bearish. This strategy therefore increases strategic opportunities by making price declines and crisis situations interesting. But this is not the only use of short selling in the trading world.

Indeed, some traders also use this method to perform a hedging strategy, also known as hedging. This involves opening a short position that can help you limit potential losses on a long position in the same asset during an unfavorable period. This short position will then be closed as soon as the trend returns to the upside. This is a very common strategy used by investors to limit risk. But this strategy can go even further. Let's imagine that you have taken a buy position on several stocks in a stock index. It is then possible to open a bearish position and thus short the value of this index and cover your losses when the shares lose value while recording gains on the overall value of the index.

However, before using short selling, you should be aware of the risks that this strategy represents despite its many advantages. Indeed, when used with a short position, there is no real limit to the potential losses. Indeed, short selling with CFDs can lead to large losses as the price of an asset can go up indefinitely while its decline will stop at zero anyway as a price can never be negative. This is why we advise you to always place a stop loss order on these positions in order to limit your losses.

 

Using leverage with a short sale:

Of course, whether you choose to short sell with the SRD or CFDs, you will also be able to take advantage of leverage on these positions. In all cases, the level of leverage offered by your broker will be the same whether you take a buy or sell position and is determined solely by the security you are investing in.

Indeed, current brokers use different leverage depending on the type of asset you are investing in and therefore depending on the financial markets concerned. Thus, the most volatile markets will offer less leverage than the least volatile markets, or even no leverage at all, in order to limit the risk of significant losses in the event of a trend reversal.

 

What are the main risks and dangers of short selling?

Short selling, while interesting for traders, is also a practice that can be dangerous. This is particularly true of short sales made through the SRD, which do not require you to hold the money to buy the securities being sold. All that is required is to pay a deferred settlement fee or DSC, which will be settled several days after the sale. Thus, if the security on which the short sale is made increases in value, the investor is forced to pay his debt.

In the same way and as we have seen above, it is possible to use leverage to make a short sale. However, this leverage effect, while it increases your potential gains, also increases your potential losses. Its use is therefore not recommended for less experienced traders who can quickly lose a large part of their capital on a single transaction because of this leverage and a bad strategy. This risk applies to both short selling and long positions.

Finally, the use of so-called automatic trading to implement short sales is also a risky practice. This is because trading software that uses this method plays on tight price spreads over time and on large scales. Also, when automatic trading deals with large volumes, it has the risk of distorting the price of an asset by amplifying declines.

 

Why short selling was banned and then allowed again:

As you may already know, it has not always been possible to practice short selling in France. Indeed, in 2008 and because of the risks and disadvantages that this strategy could represent for investors, France had decided to ban this practice. But finally and since February 2011, short selling has been allowed again provided that it is more strictly regulated than before.

Indeed, while France and other European countries such as Germany or the United Kingdom had implemented this ban, the results of this ban were not conclusive with a very limited effect. Moreover, specialists realized that this ban also posed some problems and presented certain risks. Thus, a limitation of downward speculation leads to an artificial maintenance of the price of a security and thus most often to its overvaluation. This overvaluation in turn sends a biased signal to market participants and thus makes the situation even more complex.

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