Investing

Short selling in trading: pros and cons

When it comes to stocks, short selling may be tricky to understand for beginners. In simple terms, it means betting that the stock price will tumble. That is, short selling is actually selling something that you do not own. The first question that comes to mind is this: how can you sell something you do not own? Well, brokers help.

How brokers can enable you to short sell a stock

Short selling enables you and other stock traders to capitalize on price movements in both directions; when they go up and when they go down. To be able to take advantage of a downtrend in stock, you will need to short sell it. When you send the order, the bank buys the stock on your behalf to allow you to sell it (as you borrow it from them), on the condition that you will buy it from the bank afterwards (usually at a different price). If, in fact, your prediction turned out to be correct and the stock went down, you will be buying at a lower price than you sold, effectively making a profit, and vice versa.

CFD brokers such as EasyMarkets also help you short stocks and other instruments in another way. They provide CFD instruments, which are contracts that you can trade in both directions (buying and selling). Those contracts enable you to trade on the difference in prices of the underlying assets (such as gold, for example) between the entry and exit points. You can short sell gold CFDs (among other available CFDs) even if you do not own actual gold. You will be able to make a profit if the price goes down.

Pros of short selling

The main advantage of short selling is that it enables investors to build on different opportunities in the market. If an investor believes a stock will go down, he can trade his opinion, even if he does not own the stock. Without this ability, investors would only be able to enter into long positions (buy the stock). This ability improves market liquidity and can in some cases reduce trading costs for brokers and market participants alike.

Cons of short trading

Short selling can offer opportunities and diversify positions in the market, but it also has its disadvantages. The process short selling requires can be risky. When an investor short sells a stock, he or she is borrowing the stock from the bank. This can be risky. A stock price can either move up or down (if we exclude sideways movement). The limit on its movement only exists at the lower end at zero (0). In theory, a stock price can move infinitely upwards. If it does spike up, this carries a lot of risk for short sellers.

If you have shorted a stock, and its price shot through the rough, you will incur huge losses. A case in point is the recent GameStop saga, wherein small investors bought the stock which many hedge funds had shorted. The price spiked up and many hedge funds incurred millions of dollars in losses in total, to the extent that one of the brokers, Robinhood, had to suspend traders’ ability to buy the stock. Short selling caused what is called a short squeeze in this example, and it has cost investors large amounts of money, which testifies to the risks involved in the process.

Final thoughts

It can be tempting to short sell stock if you think it is going to go down strongly, but you need to calculate the risks beforehand. Stocks might move downward in some cases, and in rare cases the price can reach zero. But that is the exception, not the rule. Despite all its merits, short selling needs to be approached with caution.