Many of the world’s stock markets have enjoyed incredible gains since 1982 and investors have been pocketing steady, consistent returns for over 2 decades now. During that time there have been a few rocky patches that may have unsettled the newbies but seasoned investors who held on have been doing very well.

So why would you want to short sell?

Given that stock markets around the world have generally been heading up and during some periods (2003 - 2008 or the tech boom) the stock market has experienced incredible bull market runs, one has to ask exactly why you would want to short sell.

Before we uncover the benefits of short selling we’ll discuss exactly what it is.

Short selling enables traders or investors to benefit from a fall in a stocks share price. Ideally your goal is to make a profit as the stock you are trading falls in value. Traditionally short selling has been reserved for the very experienced traders, but since the advent CFDs, short selling is now simple to understand and very easy to execute.

Short Selling example - Don't laugh too much!

Imagine it’s raining outside and you need to get some lunch but you don’t have an umbrella. So you ask your workmate if you could borrow her umbrella and Krystal happily agrees. Once downstairs you are approached by a suave looking guy in an Armani suit holding a bunch of papers (probably a lawyer!) and he doesn’t have an umbrella. He asks if he can buy your umbrella.

Without a moments hesitation you say “Yes, you can have it for $30” and he happily agrees.

Problem:   You have just sold something you don’t own and there is a chance Krystal (the original owner) is going to get upset.

Solution:   You run through the rain to the shops, head to the nearest umbrella shop (is there such a thing?) and you notice they are selling an identical umbrella to the one Krystal lent you. Even better news, it’s only $20.

So you hand over your $20 and discover that you have just made a $10 profit and Krystal would be none the wiser.

Who said there is no such thing as a free lunch?

Quick run down of your profitable short selling transaction

1. You sold something you didn’t own (Krystal’s umbrella) for $30

2. You bought an identical umbrella back for $20

3. You profit the difference which is $10 and netted a free lunch

Essentially that is shorting selling in a nutshell. Sorry for the corny example but I’m sure you get the point. Fortunately, when you short sell with CFDs you don’t have to find someone on the other side of the transaction (Krystal) willing to lend you the stock as your CFD broker will arrange that for you with no fuss. Most CFD providers on the Australian market will allow you to short sell the top 200+ stocks so there is plenty of opportunity to choose from.

Let’s have a look at a trading example with some real numbers. We’ll look to short sell Toll Holdings and profit as it falls in value.

Metastock® chart courtesy of Equis International

Short Selling CFD Example Trade

Short Sell 1,000 TOL shares at $8.50 - Looking to profit from a falling share price

TOL falls over a 18 day period to $7.44 and you lock in profits the day after TOL hits your stop loss.  

Calculating your CFD Profit/Loss

So you can see from the profitable example above that short selling is nothing more than selling the stock or CFD first in order to buy it back at a cheaper price. Remember, working out your profit with contracts for difference (CFDs) is simply the difference between where you get in and where you get out, regardless of whether you trade long or short.

Remember, if that position had gone the other way by the same amount it would have resulted in a loss of $1,059.26 or $124.61% of your initial outlay.

To view an example of a short sell that resulted in a loss click here.

Conditions for short selling CFDs have never been easier

Prior to the rapid growth of contacts for difference (CFDs), people who wanted to short sell had to find a full service broker who would charge like a wounded bull or bear, pun intended and the following stipulations would be put in place.

• You can only short sell on an uptick (price must head up before you can short sell it)

• You have to put up 25% margin as a minimum

• You are restricted to trading only those stocks the broker can find in their portfolio to short against.

• The ASX has short selling restrictions which means brokers in Australia cannot short sell more than 10% of a company’s shares on issue. To view the ASX short sell list (updated daily) CLICK HERE.

With the introduction of CFDs, traders now have access to the top 200+ stocks on the Australian markets and short selling is as easy as clicking the sell button first. There is no uptick rule and margins for some CFD brokers are as low as 3% up front. That means you can short sell $10,000 worth of a stock with only $300 of your money.

Short selling restrictions imposed by the ASX

Your CFD broker is not immune to the short selling restrictions imposed by the ASX but it is very rare for any company on the Australian market to get close to total short sales of 10% of shares on issue. In the USA there are no short sell restrictions and traders, fund managers and anyone with an interest in the markets can short sell as many of the company’s stock as they like. This can lead to a short squeeze.

Early 2008 say the collapse of many well established Australian companies like ABC Learning centres, Allco finance and Babcock & Brown. Hedge funds were to blame for their aggressive short selling which drove the price of these previously well capitalized companies down.

Fueling the fire was the fact that the company loans were tied to the capitalization of the company and as the share prices started to drop, company directors had to sell stock in order to free up their margin calls. A beautiful cascade in the share price developed and now you have businessmen like Eddie Groves working for the company he built as an employee minus the Brisbane Bullets and shiny red Ferrari.

Key benefits of short selling

• Most CFD brokers in Australia allow you to short sell more than 200 stocks on the Australian market

• Liquidity is tied directly to the underlying stocks that you are looking to short sell

• You earn interest every day you are short (usually the RBA minus 2-3%)

• It is the most cost effective and direct way to hedge an existing share portfolio

• Short selling contracts for difference (CFDs) is no harder than buying CFDs

• Margins and trading costs are very low compared to traditional short selling through a full service broker

Potential challenges with short selling

• Stocks can go up forever and if you short sell without a stop you can risk losing more money than you have in your CFD account

• For many it is a total mind shift and can be difficult to get your head around

• Since 1982 the market has been bullish and more recently the resource boom in Australia has seen amazing gains from 2003 - late 2007, making short selling a challenging endeavor

• Testing will show you that most short selling systems perform very poorly due to the bullishness of our markets

• If the share CFD that you short sell pays a dividend then you owe that dividend

Is this the most expensive company in the world?

Just to prove a point that stocks can go up beyond expectations, take a look at Warren Buffet’s company called Berkshire Hathaway. Imagine thinking at $20,000 that this stock cannot go up any further and ignoring your stop loss. You would want to have deeper pockets than Warren Buffett to ride out that one!

Chart courtesty of www.bigcharts.com

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For more enlightening information about trading Contract for Difference (CFDs) in plain simple english, please visit www.learncfds.com

Ashley Jessen
LearnCFDs.com

22 June 2008

Source: http://www.learncfds.com

Disclaimer: Trading Contracts for Difference carry risk where you can lose more than what you start with. View our full disclaimer here.

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