How does trading work?
Going long and short
Most people think about trading in just one direction. They imagine buying an asset ('going long') before the price begins to rise. Then they imagine selling it just as it reaches its peak to reap a profit.
While this is an excellent goal for any trader to aim for, it's by no means the only potential way to capitalise on market movements.
Opportunities can also arise in markets that are heading for a downturn, and in this section we'll see how you can trade these by 'going short' or 'short selling'.
What is short selling?
When you go long, you open your trade by buying an asset whose value you expect to rise and close it by selling - hopefully for a higher price.
To go short, you do the opposite.
You sell to open a short trade and buy to close it.
So, if you believe an asset's price is set to fall, you might decide to sell it now in the hope of later buying it back at a lower price to make a profit.
Of course, you may logically assume that you first need to own the asset concerned in order to sell it. But in fact this isn't the case: it's possible to effectively borrow the asset so you can sell it short.
How does short selling work?
The easiest way to explain this is through an example.
Let's say that shares in XYZ are trading at CHF100. Jonathan decides to borrow 10 XYZ shares from his stockbroker to short-sell, as he believes the price will soon fall.
Jonathan's broker lends him the shares, borrowing them from its own inventory, another client's holdings, or perhaps another brokerage. It sells the shares for Jonathan and credits his account with the proceeds (CHF1000).
The XYZ share price then falls to CHF80, and Jonathan decides to close (or 'cover') his trade. The broker therefore buys 100 shares for him, deducting the purchase cost of CHF800 from his account and returning the shares to their original owner.
This leaves Jonathan with a gross profit of CHF200 in his account. His broker will also charge commission for handling the transaction, the lender will require a borrowing fee, and there could be other costs for the trade, which we'll discuss shortly.
| Proceeds of sale to open trade (10 x CHF100) | CHF1000 |
|---|---|
| Cost of covering (10 x CHF80) | CHF800 |
| Gross profit | CHF200 |
Question
In the same scenario, how would Jonathan fare if XYZ's share price rose to CHF12 (rather than falling to CHF8) after he opened his short trade?Correct
Incorrect
Jonathan buys the shares back for CHF1200 and makes a gross loss of CHF200. We can see clearly how going short differs from going long: if the stock does well, Jonathan makes a loss rather than a profit.What are the limitations?
In Jonathan's trade above, he was able to borrow the shares he needed through his broker. But what if his broker didn't hold any XYZ shares and nobody wanted to lend the stock? If XYZ was 'unborrowable' at the time, Jonathan would have been unable to make his short trade.
Similarly, a lender might occasionally need to ask for its stock back while a short trade is in progress. This is known as 'being called away'. If it happens to you, even if you're not ready to close your trade yet, you may be obliged to cover.
It's also worth being aware that brokers may sometimes be unable to offer short trading facilities, for example for assets below a certain value. It's up to each brokerage to set its own criteria, so a different firm may be able to help you if this happens.
Question
When selling an asset you don't own, there are certain consequences to be aware of. For example, suppose you borrow shares in ABC to sell short, and the company then declares a dividend.The lender who provided your ABC shares, Rebecca, is due to receive this dividend. But so too is the buyer to whom you've sold the borrowed shares, George. (Strangely, at this point the shares effectively have two owners simultaneously).
ABC will pay the dividend to George, who is now the official listed owner of the shares. So who must pay Rebecca?
Correct
Incorrect
You are responsible for paying dividends to the person or firm who lends you their shares. Any other corporate actions will also need to be priced in while you're shorting shares. Clearly payments like this can reduce any profit – or increase any loss – that you make on the trade.Lesson summary
- Trading by buying an asset is called 'going long' while selling is 'going short'
- To open a short trade, you sell an asset whose value you expect to decline. To close, you buy it back (also known as 'covering'). If you can now buy the asset at a lower price, you pocket the difference.
- If an asset's value increases, short sellers will lose money while traders with long positions profit
- In order to sell an asset you don't own, you must first be able to borrow it from a lender
- You can be 'called away' from a short trade if the lender needs to reclaim the asset you've borrowed
- If you borrow shares to sell short, you will need to compensate the lender for any dividends or other corporate actions announced during the borrowing period
@ 2003 – 2023