How does shorting work?

To anyone used to buying shares, shorting is a mystery. Surely to make money you buy at one price and hope to sell at a higher one taking out the difference as a profit? Well, that's half the story.

Buy low and sell high works just fine but what if you could do it the other way around? If you sell an asset for say £100 and buy it back for £80, you make £20. And if you borrow the shares you want to sell, you never have to worry about owning them. That's the basis for short selling.

Say you are a hedge fund. You could borrow 1,000 shares when the market price is say £2 per share. Then you sell them. Let's say the price then falls to £1.50. You buy back 1,000 shares (not necessarily the exact same ones because all shares in say Tesco look the same and in that sense are fully interchangeable). You then return 1,000 shares to the originallender plus a fee. So you pocket 50p per share as a profit (£2-£1.50) less that fee.

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

MoneyWeek videos

The forex markets

Tim Bennett explains how the foreign exchange and currency markets work.

Watch all of Tim's videos here

Now, most retail investors can't do what I just described easily. But they can replicate it with a spread bet. A downbet on the same share at a price of £2 using a bet size of £10 per point, will yield the same result. Or pretty close to it! That's because a spread bet point here is a 1p movement in the underlying share price. So a 50p drop is equivalent to 50 spread betting points. And at £10 per point that's £500. Which is the same profit as the short seller would have made (1,000 shares x 50p). What's more in order to initiate the bet you'd only have put down a percentage of your total exposure via a deposit using a spread bet. So you benefit from something called 'gearing'.

In both examples, you would lose a little to 'bid to offer spreads' (the gap between the buying and selling prices on both legs of the trade). And in the case of the spread bet you'd probably want to pay for a stop order in case the bet backfires because the share price rises rather than falls. These can be easily arranged through any broker.

So, if until now you've always assumed there's only one way to make money from share price movements, think again. Shorting without stop losses can be very risky but with them, it doubles your options.