Explaining the Concepts of Shorting

What is Shorting?

If you determine that the price of an asset will fall during a specified period of time then you can open a ‘short’ trade using spread betting without the need to purchase any ownership in the security whatsoever. Instead, the practice of ‘shorting’ simply involves you focusing your attention on selecting those assets that are most likely to decline in value before expiration.

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Just with all other types of spread bets, when you conduct a shorting trade you effectively are borrowing the stock from a third party in order to activate the bet. Essentially, you are hoping to benefit from a declining market in order to record profits.

Shorting entails higher levels of risk than executing a long trade using spread betting although the profits are greater too.

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How to Short Sell by IG Index

An Example of a Losing Short Trade

Assume that your spread betting broker quotes you a spread of 240-250 for a particular company. As such, the buy price offered is $250 while the sell price is $240. Consequently, you elect to bet $10 per point on the shares of the firm falling below its present selling value of $240.

At expiration, imagine that your prediction was wrong with the value of the shares surging higher to print a new buy value of $335 while the sell price rose to $325 producing a final spread of 325-335. Your loss is determined as follows:

The difference between your final buying price of $335 and the initial selling value of $240 is 95 points. You would therefore register a total loss of 95 * $10 = $950.

A very important feature about ‘shorting’ is that there is no upper limit to the amount you could lose as the price of an asset could theoretically rise definitely. In fact, if you do not adopt caution and implement a well-tested money management policy, then a few bad bets could wipe out your entire account balance.

This is why experts advise that you should always place a ‘stop-loss’ order wherever you instigate a spread bet.

An Example of a Winning Short Trade

Envisage that your spread betting broker has offered you a spread on the stock of a particular company. The buy price quoted is $250 and the sell price is $240 producing a spread of 240-250. Consequently, you elect to bet $10 per point on the shares of the firm falling below its present selling value of $240.

At expiration, imagine that your prediction was correct with the value of the shares dropping to a new buy value of $310 while the sell price fell to $300 producing a final spread of 300-310. Your profit is determined as follows:

The difference between your initial selling price of $240 and the final buying value of $310 is 30 points. You would therefore collect a payout of 30 * $10 = $300.

In order to attain a deeper appreciation of these concepts, let us now evaluate the following example together with its associated trading charts.

Another Short Trade Example:

The first point to stress is that one of the prime advantages of spread betting is that it enables you to execute short trades as easy as long ones. However, if you are familiar with the traditional techniques of purchasing stocks for trading or investing, then the concepts of shorting using spread betting may appear a little strange to you initially.

However, professional traders advise that committing energy and time to master such crafts are well worth the effort because of the following reasons.

1. The price of assets has a strong tendency to decline more rapidly than it when it is appreciating. You therefore have better opportunities to create increased profits by executing short bets.

2. If the financial markets are advancing within a well-defined bearish channel, then you have more chances of identifying winning bets by trading in the same direction of the trend.

The diagram below demonstrates the trading performance of a particular firm over an extensive time period. Envisage that after studying this chart, you opt to execute a short trade at the point denoted by the arrow as you have concluded that the price of the firm’s shares will continue to decline in value.

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The following diagram expands that right-hand portion of the above chart so that you can evaluate more precisely how this trade progressed during its lifetime.

6sp2

Imagine that your spread betting broker quoted the following spread data for this specific firm which you utilized to assess the validity of executing a short trade. As the above diagram illustrates, the mid-price of the spread on offer was 285 as its sell value was 284 while the buy price was 286 generating a spread size of 2 points.

These features of this spread bet imply that your opening selling price would be $285 if you decided to back your analysis by activating a short trade. In other words, you are expecting that the share price of this company will continue to decline. Envisage that you also opt to wager $10 per point.

As the chart above verifies, your prediction was correct enabling you to eventually record a profit when your position closes at a mid-point value of 257. As such, the final spread is 256 and 258 producing an unaltered size of 2 points.

When you close a short spread bet you will always do so by using the quoted buying price which will be $258 in this case. Consequently, your profit can be determined as follows.

The difference between your initial selling price, i.e. $285 and your final buying value, i.e. $258 is 27. As such, your profit equals 27 times $10 producing a $270 return.

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