If trading basically consists of buying an asset and then selling it when it's worth more, then what should one do when the markets are stuck in a downward direction? Watch the assets depreciate without doing anything? Wait for better days? There is a better solution: short selling. With this controversial trading technique, it's the opposite: we are betting on the decline of the asset's price. Here's an explanation.
Short selling in the stock market involves selling an asset that one does not own at the time of sale but that one will hold at the time of delivery.
In practice, a short sale is carried out as follows:
Short selling differs from forward selling.
For example, selling a crop in advance is both a short sale (you do not own the asset yet) and a forward sale.
On the financial markets, however, we will talk about "forward sales" for derivatives, futures and options, and "short selling" for the cash markets, where transactions are both sensitive and regulated.
To understand how short selling works, let's look at the following example:
I open a trading account with $1,000. I want to sell 2 shares of Apple, whose stock price is currently $500. On my trading platform, I press the Sell button. I'm waiting for Apple's share price to drop to $490. I close my short sale position and earn $20 (500-490 × 2 = 20).
Short selling is much easier to achieve on derivatives such as CFDs than on the stock market. On a trading platform, a trader has the opportunity to directly sell a financial asset without owning it.
The 2 main advantages of short selling with CFDs are:
Short selling is a regulated technique that is widely monitored by various regulators, such as the AMF in France (for example).
Not all financial instruments are available for short selling because of their liquidity. When a trading instrument is not liquid enough, there are fewer offers to "lend it" on the market and the cost therefore becomes too high.
That's why short selling is easier with derivatives. Similarly, on the forex market, short selling is actually an integral part of forex trading since selling a currency pair implies the bearish speculation of the first of the two currencies. And when you buy the EUR/USD, for example, you are also in fact "shorting" the USD!
Short selling has been banned a few different times in history. These are typrically temporary bans related to specific market crises.
During such times of crisis, even liquid securities may no longer be available for short selling. For example, in 2011, France's AMF banned the short sale of certain securities such as AXA, BNP Paribas, Natixis and Société Générale, in order to protect these companies from speculators' abuses.