Trading: the long and the short of it
Summary: For many traders, the markets are a one-way street - and that way is up. Going long when stocks go up is a time-tested strategy, but what about those times when stocks are down? If your only plan is to buy the uptrend, you could be missing out on half of the markets opportunities.
You can profit from falling markets – and learning to go short could be a real game-changer for your trading.
What is shorting?
Take a look at any stock or index chart and you’ll see that prices rise and fall, weakening and strengthening throughout the day. So, if there are two types of market moves – up and down – you need two types of trades – long and short – to take advantage of those moves.
Think of shorting as the mirror image of going long, giving you the power to trade any market movement and take advantage of both rising and falling prices. That means more opportunities in all market conditions.
Just how do you short-sell? Instead of buying a stock to profit when its price goes up, you sell a position on a stock to profit when its price falls. When you’re ready to close your short position, you simply buy the position back, closing the position and realising the price difference.
Let’s say you spot a stock you think is going to decline due to negative company news. You open a short position at 15.75 and later, the stock falls just as you anticipated – all the way down to 15.25. There, you buy the stock to close your position, for +0.50 in your P&L.
Of course, stocks don’t always do what we expect – and in this case, if the stock rose instead and you closed the position at 16, you’d have a -0.25 loss. And in the interest of transparency, we’ll note here that the losses on a short position are, in theory, potentially high, as a long position can only go to zero, but a stock’s price could in theory keep rising. So using stop-loss orders to limit losses is often a good idea.
The tools of the short trade
Once you’ve mastered the basics of shorting, you’ll need the right tools. Stock options and futures can both be used to profit from declining prices but they do require a solid understanding of the options and futures markets.
CFDs (Contracts for Difference) are relatively straightforward. They’re traded on margin, so you can easily short a wide range of products, from stocks and indices to forex pairs and commodities like gold and oil – and you won’t have to deal with more complex concepts such as Greeks, strike prices or expiry dates.
Whichever tools you choose, with shorting in your toolbox you’ll be ready to make your move whichever way the market moves.