If you’ve watched movies about Wall Street traders such as the Academy-Awarded film The Big Short, you will be familiar with the fact that investment professionals can ‘short sell’ an asset.
Shorting an asset means that a trader stands to make a profit if the price of the security goes down, and will make a loss if the price increases.
But how does one actually short a stock? Is it even possible for retail investors to short sell, and is it actually advisable? Did you know that you could actually be paid by a broker to take a short position?
Before we begin, we want to make clear that short-selling stocks is considered a high-risk activity. When buying stocks with cash, the maximum loss you can experience is the full 100% loss of your initial deposit. When short selling, your loss will increase the higher an asset’s price goes, and there is no upper limit on a price. This means that your losses could exceed your initial deposit.
1. The traditional way to short sell a stock – using assets
The traditional way to sell a stock short is to borrow a quantity of stock from a stock lender.
You are borrowing a quantity of shares, not a sum of money. This point is absolutely critical because it means that your liability is denominated in the price of the stock, and therefore will fluctuate in value depending on the share price.
After borrowing the stock, you can immediately sell it on the open market and receive cash, less trading costs.
To close the trade after a period, the trader must buy back the same quantity of shares on the open market. If the share price has fallen over the course of the trade, this will cost the trader less than the proceeds they originally received when selling. The difference in price between these two transactions ultimately drives any profit from the short-selling activity.
The purchased shares can then be returned to the lender to satisfy the original loan, and the trade is closed.
Selling short using this traditional mechanism requires access to stock lending facilities, which are not widely provided and are difficult for retail investors to access.
Borrowing shares can also be expensive. Stock lenders will not provide a universal lending rate, but will tailor the interest rate depending on the individual security and market conditions. The annual equivalent interest rates for some stocks.
As mentioned, trading with leverage can mean loss can exceed initial deposits. It’s therefore important to protect yourself by ensuring you thoroughly research the market your looking to trading in. Additionally, utilise platform features such as demo accounts and stop losses to protect yourself from large losses.
2. The user-friendly way to sell a stock short – contracts for difference
Traders looking for a user-friendly way to gain short exposure to stock without having to negotiate the industry of securities lending is to use contracts for difference (CFDs).
Our beginners guide to CFDs explain all the intricate details of how CFDs work, but in summary, they allow investors to make a directional bet on the price movement of an index or security.
The bets can go in both directions, meaning that CFD providers allow you to bet that the price of a security will go down as well as up.
In fact, it’s as straightforward to go short as it is to go long as the trading process on a CFD platform is virtually identical.
This makes CFDs a popular way for traders to quickly trade negative news stories, or to execute a trading idea based upon a fundamental analysis of a business.
Shorting stocks or indices may also be used as part of more complex trades to hedge against overall market movements. This is done when a trader is seeking alpha and expects the price of one security to increase relative to the price of others.
Why short CFD positions can produce overnight income – theory deep dive
An unusual consequence of opening a short position with a CFD provider is that rather than paying overnight holding costs, which normally accompany a long CFD, you may actually receive income instead. This is known as a ‘positive’ holding cost.
For example purposes, let’s say that a particular broker might quote an annual equivalent holding income of 2.10910% for a trader who shorts BP PLC. Other fees such as the spread will still apply.
To understand why this curious phenomenon takes place, let’s take a deep dive into the risk and returns of the parties involved in a CFD transaction.
Why do long CFDs incur overnight holding charges
To grasp why short traders may receive holding income, it actually makes sense to first understand why a long CFD position attracts holding costs in the first place.
When a trader takes out a long CFD position, most of the trade is on margin, which means the trader hasn’t actually staked enough cash to cover the full value of the trade. A £5,000 long position on stock will probably only require £1,000 of cash to enter the trade.
The business model of a CFD provider is not to speculate on the price of financial markets. Taking the opposite side of every client trade would not guarantee a positive outcome – particularly considering the majority of trades of long positions. Taking the opposite side of all trades would therefore equate to betting against the stock market over the long term.
Therefore we should assume that a broker will always seek to offload their risk. The simplest way to do so is to actually trade the same position as the client. So if a client enters a £5,000 buy position on a stock, the broker could buy £5,000 of stock. This would allow them to settle their obligations without being exposed to market risk.
However, because trades are made on leverage, the client has not provided sufficient funds for the broker to take the full position. To do so, the broker must either use their own capital or borrowed funds. Each of which carries a financing cost of some form.
Therefore we have demonstrated that a CFD provider must incur financing costs to facilitate a client-long position without taking on market risk. It is this cost which is effectively passed back to the trader via the holding charge.
Why short CFDs can result in overnight holding income
Now we can consider how beneficial a short seller is to the CFD provider in this circumstance.
By taking the exact opposite position to the long trader, a short trader will effectively finance any return that needs to be paid to the original client.
To illustrate: if the price of a share rises, the CFD provider will make a gain on the short contract and can use this to pay out on the long contract, and vice versa.
This eliminates the net exposure of the CFD provider and therefore removes the need for capital. The CFD provider thus saves on the finance cost associated with hedging the long position and can afford to pass most of this benefit onward to the short seller.
The negative cost to the long trader will still be larger than the income paid to the short-seller, meaning that the CFD provider will still retain some element of the overnight holding transaction.
In practice, CFD providers may not choose to hedge their entire net exposure for reasons of efficiency, and may tolerate a certain amount of market risk, but this does not unravel the logic above. In this scenario, the holding cost charge provides a return to the CFD provider that compensates them for taking the risk.
3. The complicated way to short a stock – stock options
You can create a return similar to shorting stock using derivatives called put options.
A put option entitles its owner to sell a share at a pre-determined price known as the strike price.
The option has little value if the market price of the asset is above this level (the option is ‘out-of-the-money’) but as the market price of a share falls past the strike price, the option increases in value to the extent that it offers a ‘premium selling price’ over and above the prevailing market rates.
Holding a put option, therefore, provides a trader with a positive return, so long as the market value of the share is below the strike price by more than the cost of acquiring the option.
The precise value of an option at any time will be a function of the underlying asset price, the strike price of the put and the maturity date of the option. These factors are combined and will output a factual value for the put using the Black-Scholes model, for example.
Options are not appropriate for retail investors and are not offered by trading platforms to beginners in the UK, owing to their steep learning curve, and use of leverage. Leave options trading to the professionals in hedge funds.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
Please note that past performance is not a reliable indicator of future results.