How Short Selling in CFD Trading Works
Reading time: 8 minutes
Short selling is a strategy that can be used in many financial markets, including the Contracts for Difference (CFD) market. However, there is a difference as compared to traditional stock trading.
Short Selling vs Traditional Stock Trading
The 'buy low, sell high' principle is often associated with traditional stock trading (as well as investing). You purchase the shares of a company in anticipation of asset appreciation, expecting its value to increase over time, and you reap the profits upon selling them. Often, most traders hold stock for an extended period to maximise gains from long-term growth trends.
In CFD trading, short selling involves selling CFD contracts for an underlying asset you believe will drop in price. Unlike traditional stocks, which require borrowing stock, selling it, and repurchasing it at a lower price, CFD short selling is streamlined. You’re not selling a stock but a contract representing its price movement without the need for physical ownership or borrowing.
How It Works
If your analysis suggests a stock's value could depreciate, you could consider executing a sell position (‘going short’). If your analysis is correct, and the share price decreases, you'll buy the CFD back at a lower price (by closing the position), and the difference is your return. Conversely, if the stock’s price rises, the difference becomes your loss.
Company A is overvalued and its price might dip in value soon. In this scenario, you're a trader and analysed that the company is about to face some news that will likely lower the value of the stock price, which currently stands at US$100.00.
Here's how you could execute a short sell on a CFD:
- Open a Sell Position: Based on your analysis, you decide to short-sell Company A to generate a return from potential depreciation; you open a sell position for 100 CFDs, equivalent to 100 shares of Company A. Since it’s a CFD, you don’t need to own these shares. You’re merely entering a contract based on the price movement.
- Leverage and Margin: Assume your CFD provider offers a leverage of 10:1 for stock CFDs. For the US$10,000.00 exposure (100 shares x US$100.00) you've taken, you only need to provide US$1,000.00 as the margin, thanks to the leverage.
- The Market Reacts: As expected, the market reacts to the negative news, and Company A’s stock price falls to US$90.00 per share. Your prediction was correct.
- Closing the Position: Seeing the market's reaction, you capitalise on your successful forecast and close your position. The stock dropped by US$10.00 per share, so for your 100 CFDs, this equates to a US$1,000.00 profit.
Here's a balanced overview of both the advantages and disadvantages of short selling in CFD trading:
- Hedging Opportunities: If you think certain investments might decrease in value, short-selling CFDs can help hedge your portfolio, potentially offsetting the losses with gains from your CFD positions.
- Leverage Risks: While leverage can lead to excess returns, it can equally lead to losses. A poorly judged position can result in losing more than your initial investment, especially in volatile markets.
- Market Diversification: CFDs enable trading across a wide range of financial markets — Commodities, Indices, Forex, Cryptocurrencies, etc. — often from a single platform. This diversity allows traders to exploit opportunities across different asset classes.
- Risk Warning: Short selling depends on predicting market movements accurately. If the price of the stock goes up instead of falling, the potential losses can be substantial, especially when leverage is involved.
- No Ownership: Trading CFDs involves dealing with the price of an asset without owning it, removing the need for physical purchase, ownership, and direct asset exchange or borrowing, simplifying the short-selling process.
- Emotional Pressure: The pressure of short selling, especially during volatility in market conditions, can be intense. The stress of potentially unlimited losses can impact decision-making and risk management.
Tips for Short Selling in CFD Trading
You’ve learnt how short selling works and its advantages and disadvantages in CFD trading. But what can traders use to evaluate potential candidates for short positions? Here are some helpful tips for your consideration:
- Fundamental Analysis: Dive into a comprehensive fundamental analysis of the asset. Check out financial health indicators like revenue trends, economic data, debt loads, or recurrent losses, which might signal an upcoming downtrend. In CFD trading, weak underlying assets can present profitable short selling opportunities.
- Technical Analysis: Use technical indicators and chart patterns to identify potential entry points for short or long positions. Look for signs of a weakening trend or overbought conditions.
- Market Sentiment: Be in tune with the prevailing market sentiment. News and events, including legal troubles, unfavourable regulatory developments, or problematic product launches, can drive rapid sentiment-based price movements in CFD trading.
- Industry Trends: Keep a finger on the pulse of broader industry trends. Challenges or systematic downturns in a particular sector can trigger widespread declines in related assets, making them ideal candidates for short positions.
- Earnings Reports: Keep an eye on upcoming earnings reports. In CFD trading, earnings announcements are pivotal moments that can precipitate significant price swings in stocks. Positions can be taken based on projected performance, with disappointing results often leading to declines in asset prices.
- Risk Management: Always have a clear risk management strategy in place. Set stop-loss orders to limit potential losses and stick to your trading plan.
The Short Take
In conclusion, short selling in CFD trading allows for potential returns from falling asset prices. It involves selling a CFD contract based on an underlying asset with the expectation of buying it back at a lower price with the aim of generating a return from the difference.
Ready to Start Trading CFDs?
FP Markets is the premier destination for CFD trading, offering access to over 10,000 instruments across four continents. Additionally, we offer over 70+ currency pairs, together with a wide range of Commodities, Indices, Individual Shares, ETFs and Digital Currencies. As a globally regulated and award-winning Forex and CFDs broker, FP Markets is committed to delivering exceptional service, competitive pricing, and cutting-edge technology.