How Short Selling Works: A Beginner's Guide to Shorting

Short selling is a trading strategy that allows traders to potentially profit when an asset's price falls. It typically involves selling borrowed shares and buying them back later, ideally at a lower price.

Unlike traditional investing, where investors buy an asset hoping its value will rise, short selling involves taking a position based on an expected price decline.

You might use short selling to speculate on falling markets or to hedge investments you already hold, which means offsetting some of their potential losses. However, the strategy carries significant risks, particularly when leverage is involved.

This guide explains how short selling works, how it differs from shorting through CFDs, and the main costs and risks to consider.

Key Takeaways

• Short selling allows traders to potentially profit from falling prices, although losses occur if the market moves against the position.
• Traditional short selling involves borrowing shares, selling them and buying them back later to return to the lender.
• CFDs offer another way to take short positions without owning or borrowing the underlying asset, but they involve trading costs and leverage risks.
• Short selling has an uneven risk profile. Potential gains from a conventional short share position are limited by the price falling to zero, while potential losses are theoretically unlimited.

What Is Short Selling?

Short selling, also known as shorting or going short, means selling an asset first and aiming to buy it back later at a lower price.

In a traditional long position, an investor buys an asset and hopes to sell it later at a higher price. Short selling works in the opposite direction. The trader sells first and aims to buy back at a lower price.

For example, a trader might short a share at $100 and close the position when its price falls to $70. The difference represents a gross gain of $30 per share, before trading costs.

However, if the share price rises to $120 instead, the trader faces a loss of $20 per share, excluding fees. The key difference is that long positions benefit from rising prices, while short positions benefit from falling prices.

How Short Selling Works: Step by Step

Traditional short selling involves borrowing shares through a broker, selling them on the market and later buying them back to return to the lender.

The process generally follows four steps:

1. Borrow shares: The broker arranges to borrow shares from an available lender.
2. Sell the shares: The borrowed shares are sold at the current market price.
3. Buy them back: The trader later buys the same number of shares on the market to close the position, a step known as covering.
4. Return the shares: The shares are returned to the lender, and the trading result is calculated after applicable costs.

Example of Short Selling

Suppose a trader borrows 10 shares in a company and sells them for $100 each.

The total sale value is $1,000.

If the share price falls to $70, the trader can buy back the 10 shares for $700.

The gross profit would be:

$1,000 − $700 = $300

However, if the share price rises to $130, buying back the shares would cost $1,300, resulting in a $300 loss before fees.

This example shows how short selling works in practice, and why short sellers need to consider both potential gains and the possibility of prices rising instead.

What Does It Cost to Short Shares?

Traditional short selling can involve several costs and obligations.

• Stock borrowing fees: Charges for borrowing shares, which may increase when shares are difficult to borrow.
• Trading commissions: Fees charged by the broker for opening or closing trades.
• Dividend payments: Short sellers may need to compensate the share lender for dividends paid while the position remains open.

Traders may also monitor short interest, which measures how many shares have been sold short and remain outstanding. It is a market indicator rather than a direct trading cost.

How Does Short Selling Work with CFDs?

Contracts for Difference (CFDs) allow traders to take short positions without borrowing or owning physical shares.

A CFD is a derivative contract that tracks the price movement of an underlying asset, such as a share, index or commodity. When a trader opens a short CFD position, they are speculating that the underlying asset's price will fall.

If the price declines, the position may generate a gain. If it rises, the trader incurs a loss. The difference is settled financially when the position is closed, rather than through the delivery of shares.

CFDs are commonly traded using leverage, meaning traders can gain exposure to a larger position with a smaller initial margin deposit. This increases both potential gains and losses.

Learn more in our guides to CFD trading, what you can trade with CFDs and short selling cryptocurrency.

What Are the Costs of Short Selling with CFDs?

Although CFDs remove the need to borrow physical shares, they still involve trading costs.

These may include:

• Spreads and commissions: The spread is the difference between the buy and sell price. Some brokers also charge a separate commission.
• Overnight financing: Positions held overnight may incur a financing charge or receive a credit, depending on the instrument and the broker's terms.
• Dividend adjustments: Short share CFD positions may be subject to a debit when the underlying share goes ex-dividend, which is the date from which new buyers no longer qualify for the upcoming dividend.

Overnight financing rates can depend on benchmark interest rates, broker charges and the type of position held.

That's why it's worth checking the full cost of keeping a short CFD position open, especially if you plan to hold it for several days.

What Are the Risks of Short Selling?

Knowing how short selling works also means understanding its risks, which differ from those of buying shares outright.

When an investor buys a share, the maximum loss is generally limited to the amount invested, assuming no borrowing or additional obligations. With a conventional short share position, potential losses are theoretically unlimited because a share price can continue rising.

For example, a share shorted at $100 could rise to $200, $300 or more. The trader would still need to buy it back to close the position. By contrast, the maximum gross gain from that short share position is $100 per share if the price falls to zero.

What Is a Short Squeeze?

A short squeeze occurs when a heavily shorted asset rises sharply in price, putting pressure on traders holding short positions.

As losses increase, some short sellers may buy back shares to close their positions. This additional buying can push the price higher, potentially encouraging more short sellers to exit.

Short squeezes can cause rapid price movements and substantial losses, particularly for leveraged positions.

Margin Calls and Forced Position Closures

Short CFD positions typically involve margin, which is the amount of capital required to open and maintain a leveraged trade.

If the market moves against a short position, unrealised losses reduce account equity.

When the account's margin level falls below the broker's required threshold, the broker may issue a margin warning or close positions automatically.

Under UK retail CFD rules, margin close-out protections apply, but don't assume you'll always get a warning or have time to add funds before a position is closed.

Can Stop-Loss Orders Limit Short Selling Risk?

A stop-loss order can help limit exposure by instructing the platform to close a position when a specified price level is reached.

However, a standard stop-loss does not guarantee execution at the requested price.

During sharp price movements or market gaps, an order may be filled at a less favourable price.

Some brokers offer guaranteed stop-loss orders, which provide additional price protection subject to their terms and any applicable charges.

Risk management tools can help reduce exposure, but they cannot remove the risks of short selling.

Conclusion

Short selling allows traders to take positions based on falling market prices. It can also be used to hedge certain investment exposures.

However, short positions carry significant risks, including rising prices, borrowing or financing costs, short squeezes and potential margin close-outs.

Understanding how short selling works is important before considering either traditional share shorting or CFD trading.

Before you open a position, weigh up the costs, the risk management tools available and the potential impact of leverage.

For more information about platform features and trading charges, explore our CFD broker reviews.