How to short stocks the right way: A step-by-step guide

Is short selling available worldwide?

Short selling is legal across many global financial markets, including Europe. While it's a widely accepted trading strategy, strict regulations ensure that the practice remains transparent and doesn't lead to market manipulation.

In the European Union (EU), short selling is regulated by the European Securities and Markets Authority (ESMA). Rules such as Regulation (EU) No 236/2012 govern short selling, requiring traders to borrow or locate shares before initiating a short sale. Naked short selling - selling shares that haven't been borrowed - is prohibited.

CFDs are a popular way to short-sell in Europe and other regions, offering traders access to global markets. However, regulators often impose additional restrictions during periods of extreme volatility, such as temporary bans on short selling that were seen during the 2008 financial crisis and the COVID-19 pandemic.

While legal, short selling can provoke debate. Some argue that it may exacerbate market downturns or lead to unfair manipulation. In contrast, others defend it as a valuable tool that adds liquidity to markets and helps expose overvalued or poorly managed companies.

The risks of short selling

Short selling, particularly with leveraged products like CFDs, carries significant risks. Understanding these risks is crucial before engaging in this strategy.

CFDs are leveraged products, allowing traders to control larger positions with a smaller initial margin. While this can amplify potential gains, it also increases the exposure to losses. Without proper risk management, traders can quickly face losses that exceed their initial investment.

Here are the main risks associated with short selling:

1. Unlimited loss potential

One of the most significant risks in short selling is the possibility of unlimited losses. When you buy a stock, the most you can lose is the amount you invested—if the stock drops to zero. However, when you short a stock, its price could theoretically rise indefinitely. As the stock price increases, your losses grow without a cap, making this strategy inherently risky.

2. Market volatility

Volatility is common in the stock market, but short sellers are especially vulnerable to sudden price spikes. If a stock's price rises quickly, short sellers can be caught off guard, forcing them to close their position at a loss. Unpredictable market events - such as unexpected positive news or earnings surprises—can rapidly drive prices up, making short positions dangerous.

3. Short squeeze risk

A short squeeze occurs when a stock that has been heavily shorted starts to rise sharply in price. As the stock climbs, short sellers rush to buy back the shares to cover their losses, which drives the price up even further. This cycle can lead to substantial losses for those who haven't exited their positions early.

The infamous GameStop short squeeze of 2021 is a prime example of how a short squeeze can lead to unexpected financial consequences for traders.

4. Regulatory risks

Regulations around short selling can change depending on market conditions. Authorities sometimes impose temporary bans on short selling during periods of market instability, as they did during the 2008 financial crisis and the COVID-19 pandemic. Such restrictions can limit your ability to exit positions at the right time, increasing your loss exposure.

5. Timing risks

In addition to market volatility, timing plays a crucial role in short selling. Stocks can remain overvalued for longer than expected, causing you to hold your position and incur additional interest on borrowed shares. If your timing is off and the stock doesn't decline quickly, the costs of maintaining the short position can erode your profits or even result in a loss.

6. Costs of holding CFDs

CFDs incur daily holding costs, which can erode profits over time. Additionally, maintaining a short position for an extended period may lead to higher fees and reduced profitability.

7. Margin calls

If the market moves against you, brokers may require additional funds to maintain your position. Failure to meet these margin calls can result in forced liquidation at a loss.

Short selling example

The following example illustrates how short selling works.

Let's say you've identified a stock trading at USD 100 per share that you believe will decline in the near future due to poor financial results.

Here's a step-by-step breakdown of what happens:

1. Open a short position

You open a CFD position to "short" 100 units of a stock priced at USD 100 each, effectively speculating that the stock will drop. The notional value of the trade is USD 10,000 (100 x USD 100).

2. Price drops

The stock price drops as expected due to disappointing quarterly results. The value of the CFD position now reflects a price of USD 70 per unit, making the total value USD 7,000 (100 x USD 70).

3. Close the CFD position

You close the CFD position at the lower price, locking in the difference between the opening and closing values.

4. Calculate your profit

The difference between the opening value (USD 10,000) and the closing value (USD 7,000) is your gross profit: USD 3,000. Fees, holding costs, and interest (if applicable) will reduce the net profit.

However, this same trade could have gone wrong. If the stock price had risen to USD 130 per share instead, you would have needed USD 13,000 to buy back the 100 shares, resulting in a USD 3,000 loss. With CFDs, leverage could further amplify this loss, making risk management critical.

Conclusion: Weighing the risks and rewards of short selling

Short selling can be tempting to profit when you think a stock is heading downhill, but it's not without challenges. The potential for big rewards is real, but so are the risks— especially when using leveraged products like CFDs.

As a result, timing and patience play a massive role here, and things like short squeezes and market volatility can turn the tables faster than you'd expect.

For those who've done their homework and can endure the unpredictability, short selling can be another tool in your trading kit. Just remember that this strategy isn't for everyone, so weigh the risks carefully before diving in.