By using advanced trading techniques like shorting (or short selling), traders can make profits even during a bear market. While holding stocks in such cases will often generate losses, leveraged trading allows experienced traders to short-sell without actually owning any assets.
As with every financial instrument, there are both benefits and risks to shorting. In today’s article, we’ll be covering them to help you decide whether short selling will be valuable for you.
Introduction to leveraged trading and short selling
The basic concept of leveraged trading is increasing the number of shares that take part in a trade beyond a trader’s capital. When leverage is used in trading, the trader only has to pay a small portion of the full value of a given transaction. In the UK, this leverage is capped at 1:30, meaning with only £100, a trader could potentially buy or sell £3,000 worth of shares. In most types of leveraged transactions, no assets exchange hands, which means no stamp duty needs to be paid.
What exactly is shorting? Short selling makes use of leveraged trading through Contracts for Differences (CFDs), futures, forwards, or other leveraged financial instruments. In such cases, a contract between two parties is formed, in which a trader predicts the price will change. At the end of the contract, the trader receives a payout based on the accuracy of their prediction.
Benefits and risks of shorting
One of the biggest advantages of short selling is the ability to make profit in a bear market, when stock value is generally falling. It allows traders to make profit when they know a stock is going to fall, without having to actually acquire any type of asset. Shorting also provides the ability to hedge easily, offsetting traders’ long positions when they know they are about to lose value.
Leverage in shorting presents another potential advantage – the ability to achieve much greater Return on Investment (ROI) than with traditional trading. By having to pay only a fraction of the full trade value up front, traders can make transactions that would otherwise far exceed their fund limit.
While there are many advantages to shorting, there are also risks involved. For shorting to be profitable, your prediction needs to be very precise. If the stock price ends up going up instead of down, you might be exposed to heavy losses. The loss potential is much higher than in traditional trading, so every market move needs to be very carefully planned.
Shorting also creates the potential for a short squeeze, where traders gather in mass to short sell at a single time, causing stock prices to become even more volatile. This could end up in massive losses for everyone involved, as the prices don’t follow previous predictions, and platforms could recall the contracts under certain circumstances.
Conclusion – is short selling worth it?
Shorting can be risky. The GameStop short squeeze from 2021 is probably the most well-known such incident in recent years, but definitely not the first one. In 2008, Volkswagen’s stock reached the value of over €1,000 per share in a matter of days, causing short selling costs to skyrocket. Short sellers were facing massive losses, which only shows why you should always be careful about following hype in trading.
All in all, there are pros and cons to short selling with leverage and it takes a skilled trader to make safe profits. When utilised correctly, shorting can be a great addition to your trading portfolio, but always keep the risks in mind and base your trades on extensive market research.
