What Is Short Selling?

Yes, the idea of short selling is still elusive to some people. Short selling is simply an opportunity to profit when the price of a share goes down, by using an instrument and a broker that allows you to sell a share or CFD and then later buy it back. Sounds like share trading in the reverse order, doesn't it? This article by Jon will help you to appreciate the advantages and the risks in "going short". Here it is:

Short selling as a technique is commonly used to profit from a falling or 'bear' share price.

The stock market does not always go up. There are periods when most stocks on the stock market are making lower troughs. These periods are known as bear markets.

There is no exact definition of a bear market; it will vary between market participants. An investor may class a bear market, as a 2-year period of overall downward movement.

Whereas a medium term trader may consider 3 months of downward movement as a bear market.

A bear market may occur in a select group of stocks, such in the same industry sector. A more severe bear market may occur across all stocks on a particular stock exchange.

Trading an upward move in a share price is called going 'long'. A long position is simply when a stock is bought with the objective of selling it at a higher price. Profiting from a downward move on a stock is referred to as a 'short' position. A short position is when a stock is sold (without owning it) with the objective of buying it back at a lower price.

By trading both the long and short side of the market you can obtain much better consistency in your trading. When the market is generally bullish your long trading system will perform well and when the market is generally bearish your short trading system will perform well. The end result is consistent returns, regardless of market conditions. Shorting a stock can be achieved in a number of ways:

* Short selling the physical share
* Selling CFD’s over a share
* Buying put options over a share
* Selling call options over a share
* Buying put warrants over a share

The least complex of the four techniques is short selling the physical share. Short selling involves dealing directly with the share, whereas the other techniques involve dealing with financial products that move as a result of a movement in a share price, which adds further complexity.

When you open a long position, you will make money if the share price goes up and you will lose money if the share price goes down.

When you open a short position, you will make money if the share price goes down and you will lose money if the share price goes up.

When you enter a short trade you are selling borrowed shares*. The proceeds of the sale is held by your stock broker until the borrowed shares are returned when you close your position by buying shares in the market place. The profit or loss for the trade is then credited to or debited from your trading account.

Most stock brokers firms will use a large financial institution such as AMP to borrow stock from. Because AMP manages funds, they have a very large and diverse portfolio. There are borrowing costs associated with opening short positions which are discussed in the section on brokers.

But always remember the risk. If a short position is opened, the loss is unlimited, as the price can theoretically increase to infinity whereas the maximum profit is limited to the original proceeds of the sale. Whereas if a trader takes a long position, their risk is limited to the total cost of the shares. The potential profit is unlimited, as the price can theoretically increase to infinity.

It is strongly suggested you go to http://www.asx.com.au/supervision/rules/asxl/asx_section_19.pdf and read the ASX rules on Short Selling.

*From a conceptual point of view, people often find it hard to accept that a share can be sold without actually owning it. This is possible as the shares are lent to the trader by an institution to cover the position. This process of borrowing stock allows short positions to be initiated without extra shares being created.

Jon Lynch is Marketing Manager of the Capital Intelligence Group of companies, including HomeTrader - Australia’s leading stock market education centres. We focus on teaching you how to create wealth through the share/stock market using a customised trading plan or system that is right for you, your situation and your goals. Visit our website and register for your free introductory DVD "Learn To Make Money On The Stock Market" at http://www.learnshares.com.au

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