Market Dynamics – What Is Behind A Short Trade?

*Explaining the principles of how a short trade works and what happens when you click sell on your broker platform*

I am going to do something a little different in this blog post and explain to you the theory behind the short trade. For some of you, this may seem stupid because you already know what a short trade is and how they work but for the remaining majority, you may have never learnt about the operations behind opening a short position on a financial instrument.

Trading the financial markets has never been easier, that is a fact. More brokers, increased liquidity and greater leverage and new financial products all add up to more retail traders being able to trade than ever before. Broker platforms become even easier to use and the increased use of technology means traders and brokers are required to less groundwork when trading.

This can have its downsides as a lot of new retail traders coming in to the market do not understand the basic principles of market dynamics and how the financial markets work. This has lead me to write todays blog post… what is a short trade.

There are two main types of directional trades that you can make, buying (going long) and selling (going short). A good trader goes long in a bull market and goes short in a bear market. This is the basics to trading where you are wanting to buy low and sell high.

Going long on a financial instrument is simple. You buy a set number of contracts of a stock, index tracker fund, derivative or commodity from a seller in the hope that price is going to rise. You then sell when the price is higher and pocket the difference in price as a profit (or loss).

However, going short is actually a lot more complicated.

Entering a short position is done when you are wanting to bet on the price of a financial falling in the future. It is the opposite (and more complex) than a long position because you are technically selling an asset/security that you don’t own. For example, if you want to short sell shares in Apple you would need to obtain shares in Apple first in order to sell them but you don’t want to buy the shares because you think they are going to fall in price, not gain. So you must borrow them.

You can technically short any financial instrument so long as you can find someone who owns shares/contracts who is willing to lend them to you. Below are two examples of short trades explaining how they work and how your profit/loss is calculated.

Short Trade Example – Microsoft, profitable short trade.

Let’s assume you think that the next Microsoft laptop to be released is going to be rubbish so you want to short the stock in the hopes that the bad product will cause the value of Microsoft shares to decline.

The current share price of Microsoft is $158 per share. You want to short 100 shares of Microsoft which is essentially selling the shares but you do not own any. The first step is to find someone who owns 100 shares of Microsoft that they are willing to lend you.

You find Mr M. Oney who is willing to lend you 100 shares of Microsoft at a rate of 5% per year. You obtain the 100 shares and immediately sell them at $158 per share for a total of $15,800.

You now have $15,800 extra capital in your brokerage account.

You then wait 3 months for the next Microsoft laptop to get released and as expected, it is terrible and the price of Microsoft shares drop from $158 down to $120 per share.

You then buy 100 shares of Microsoft on the financial markets at $120 per share for a total price of $12,000 using the money you gained from selling the 100 shares you borrowed. You give the 100 shares of Microsoft back to Mr M. Oney who lent them to you along with $197.50 in interest payments.

You then are left with $3,602.50 in profit.

Below is the quick maths version of this trade:

  • Borrow 100 MSFT* @ $158
  • Sell 100 MSFT @ $158 = $15,800
  • Buy 100 MSFT @ $120 = $15,800
  • Return 100 MSFT to lender plus $197.50 for 3 months interest. Interest = ($15,800 *5%)/4
  • Your profit = $15,800 – $12,000 -$197.50 = $3602.50

*MSFT = Microsoft Shares. This example excludes broker commissions & taxes.

Short Trade Example – US Crude Oil Commodity, non-profitable short trade.

Let’s now assume you are wanting to bet on the value of US crude oil dropping in price. You believe that there are 1 million barrels of US crude oil hidden in a barn in a small farm in Oklahoma and that when they are found, the price of crude oil is going to fall massively. The current market price of US crude oil is $63 per barrel and you think that if your analysis comes true, the price of crude oil will drop to as low as $50 per barrel.

You manage to find a wealthy Texas oil king who is willing to lend you 1,000 contracts of US crude oil at an interest rate of %8 per annum and storage costs of $1000 per annum. You confidently accept.

You immediately sell the 1000 contracts of US crude oil, keep the $63,000 extra trading capital in your brokerage account and wait by your computer for the news of the oil discovery… but it doesn’t happen.

6 months later the price of oil is still steady at $62 per barrel. You remain confident in your analysis and continue to hold the short trade because you feel the hidden oil barrels will be discovered within the next 6 months… but it doesn’t happen.

Instead, the price oil begins to rise on the news that Iran has slowed output due to military actions taking place in their country. US crude oil now sits at $68 per barrel.

You are now on the hook for 1000 contracts of US crude oil with a current market price of $68,000 and are due to pay the Texas oil king $6,040 in interest and storage fees. You decide to wait another 3 months.

It is now 15 months after you entered the short position on US crude oil and the price has slowly risen to $70 per barrel. You decide to cut your losses and sell.

You purchase 1000 contracts of US crude oil at $70 per barrel for a total cost of $70,000 and return them to the Texas oil king. You must also pay him an extra $1,510 for 3 months interest and storage fees.

You have therefore had to use $14,550 of your trading capital to cover the losses incurred from the increase in value in the price of US crude oil and interest and storage fees. In this example, your costs of borrowing and storage actually exceeded your net loss in value of the contracts themselves after only 15 months.

Below is the quick maths version of this trade:

  • Borrow 1000 USOIL* @ $63
  • Sell 1000 USOIL @ $63 = $63,000
  • Buy 1000 USOIL @ $70 = $70,000
  • Return 1000 USOIL to lender plus $197.50 for 15 months interest and storage fees. Interest = (($63,000 *8%)/12)*15. Storage = ($1000/12)*15
  • Your loss = $63,000 – $70,000 – $7550 = $14,550 LOSS

*USOIL = US Crude Oil Contracts. This example excludes broker commissions & taxes.

Limitations of short selling:

One of the main problems with short selling is that your potential losses are theoretically infinite. If you buy shares in a company, the maximum you can lose is the total value of the shares you hold because the value of a publicly traded company can not go below zero. However, if you short sell shares in a company, your theoretical loss is infinite because there is no limit to how high the value of a company can go. This is why it is so important to have stop loss orders in place at predetermined risk levels.

Another downside of short selling any financial instrument is borrowing costs (interest). These are usually calculated on a % basis and if the markets move up/down/or sideways they will always be charged to you. The longer you hold a short position, the more it will cost you in fees and this will therefore reduce your total profit (or increase your losses). The only exception to this is when you short certain FX currency pairs because it is possible to find positive carry trades when short selling one currency against another. This means you actually get paid interest to hold a short position so the longer you hold the trade, the more you “profit” you make from interest payments.

This is covered in extensive detail in my Mastering the Markets – Retail Trading Course.

End Note:

Fortunately for you as a retail trader, your broker organises all of this for you. So now if you want to bet on the value of a financial instrument falling in the future, your broker will find someone willing to lend you shares/contracts for the instruments that you are wanting to sell and the costs of borrowing are all automatically calculated for you and added/subtracted daily to your profit & loss. All of this is now usually done in the blink of an eye so you can simply press sell and enjoy the rewards.

Useful Links:

All my technical analysis is done using the TradingView platform. You can get access via the link below.

My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.

Thanks for reading and please don’t forget to LIKE, SHARE and FOLLOW my blog to stay up to date with the latest market analysis and trading education posts.

DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.

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