Introduction to the Financial Markets: Trading Indices and Short Selling

The financial markets can be a daunting place for new investors, with various asset classes and investment strategies to consider. One way to potentially profit from market movements is through short selling, which involves opening a trade that earns a profit when the market falls in price.

Traditionally, investors could only profit from markets that went up in value, but short selling has opened up new opportunities. This guide will provide an introduction to short selling and how it can be used to trade shares, indices, and other financial instruments.

What is Short Selling?

Short selling is the practice of opening a trade that profits from a fall in the market price of an asset. Instead of buying low and selling high, short selling involves selling high and buying low. To open a short position, a trader sells at the bid price and buys back at the ask price when it’s time to close the trade.

Short selling is not limited to foreign currencies but can be applied to almost any market that can be bought. Shares, for example, can be shorted by borrowing them from a broker and selling them on the market.

Short Selling Shares

Short selling shares involves selling stocks to open a position. Since the trader doesn’t own the shares, the broker lends them to the trader and sells them on their behalf. When the trader closes the trade, the broker buys back the shares using the funds in the trader’s account. If the shares are worth less than when they were sold, the trader profits from the difference.

Short selling shares can be confusing, so let’s use an example to illustrate the process. Suppose a trader wants to short Exxon Mobil when its stock is at 33.9/40.1. The trader tells the broker to sell 50 Exxon Mobil shares at 33.9, and the broker lends the shares to the trader and sells them for $1,695. If the stock falls to 31.1/31.3, the trader closes the trade by buying back 50 shares at 31.3 for $1,565, leaving a gross profit of $130.

Short Selling with Derivatives

Short selling can be challenging for individual traders to execute since not all brokers offer the service. However, derivatives such as Contracts for Difference (CFDs) enable traders to go long or short without borrowing stocks. With CFDs, traders can sell any market that they can buy, including forex, commodities, and indices.

Hedging with a Short Trade

Short selling can also be used as a means of hedging, a form of insurance against negative market moves. When traders hedge with a short trade, they open a position that profits if an existing long trade incurs a loss. For example, if a trader owns several Dow Jones stocks in an investment portfolio but is worried about an impending bear run among US blue-chip shares, they can sell five Wall Street CFDs. If US shares do fall, then their share losses may be partially offset by the profits from their CFD.

Risks of Short Selling

Short selling can be riskier than buying since there is no limit to how much a market can rise. When buying, traders know precisely what their maximum loss could be. In contrast, when shorting, traders risk losing their entire invested capital if the market rises significantly.

Using risk management tools such as stops and limits is crucial when going short. Stops and limits can help limit losses and protect profits. Shorting may also come with additional costs to cover the capital that brokers lend traders to open trades.

Conclusion

Short selling is a powerful tool that enables traders to profit from market movements in any direction. Traders can short sell shares, indices, and other financial instruments through brokers or derivatives such as CFDs.

In summary, short selling is a way to profit from markets that are falling in value. It can be done by borrowing shares from a broker and selling them on the market, then buying them back at a lower price to make a profit. Alternatively, it can be done with derivatives such as CFDs, which allow traders to go short without borrowing shares.

Short selling is not without risks, as there is no limit to how much a market can rise, which means that losses can exceed the invested capital. Therefore, it is important to use risk management tools such as stops and limits and to understand the potential costs associated with short selling, such as borrowing costs and commissions.

Overall, short selling can be a valuable tool for traders and investors looking to profit from market movements. However, it should be used with caution and only after careful consideration of the risks involved. By understanding how short selling works and the various ways it can be done, traders can expand their trading strategies and potentially increase their profits in both rising and falling markets.