Short Selling CFDs – How it Works

Those readers who are only familiar with long term share trading might find the concept of short selling somewhat frightening and counterintuitive. The truth is that short selling has many benefits and when approached in the right way it can not only prevent losses, but also result in significant profits to the savvy trader.

What is short selling?

Most of us are familiar with the concept of buying an asset, keeping it for some time and then selling it at a profit later on. In real life all assets do not increase in value over time however – and when we enter the world of currency trading, stock trading or commodity trading, these financial ‘assets’ often depreciate in value as often as they appreciate.

Wouldn’t it be nice if there was a way to benefit from these price declines? The good news is that there is indeed such as way and that way is called short selling.

Short selling simply involves selling an asset at the current price and buying it back later at what the trader hopes to be a lower price. If the price of the asset goes up in the meantime the unfortunate trader will have to buy it back at the higher price.

Reasons for short selling

There are two main reasons for short selling a financial asset. The first is when the trader believes that the value of that asset will decline in the near future. The second is when someone already owns the asset (e.g. a share, currency or commodity) and he or she wants to hedge the position against possible price declines.

CFDs and short selling

While short selling of actual financial assets such as shares is rather difficult, unless the trader ‘borrows’ the shares from his broker, financial derivatives such as CFDs make it easy to short sell any financial asset – including shares, currencies and commodities.

Short selling a CFD is as easy as ‘going long’ on the same CFD. Take the example of Company ABC shares which are currently trading at $100 per share. The trader believes

that the price will drop in the near future and therefore ‘goes short’ on CFDs on these shares.

The risk profile of the trade looks like this:

Fig. 11.01(a)

If the price of ABC shares drop below $100, the trader will make a profit. Given that these trades take place on margin, the profit could be substantial. A CFD with a 10% leverage factor will make $10 profit for every $1 drop in the share price.

If the price goes up, however, the same trader will lose $10 for every $1 increase in the price. That is the nature of the beast – leverage can work both for and against the trader.

The maximum profit for this trade is limited to the amount of the share price multiplied by the leverage factor. The maximum loss is theoretically unlimited.

Interest and dividends

The CFD account will normally be credited with interest on the open short position. On the other hand, the account will be debited with the amount of dividends that are declared on the share.