How does shorting work? Profit when price drops


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When you’re shorting or short selling you’re trying to profit from falling prices. But how does shorting work? In this blogpost I’ll explain exactly what shorting means with some tasty examples.

Shorting is profiting from falling prices

It makes sense that you make a profit if the assets you have purchased increase in value. If you sell those assets for a higher price than what you paid for them, the difference between the buy and sell is your profit.

But that the fact you can also make money when an asset decreases in value makes a lot less sense. Yet as an online trader you can make a profit by shorting that asset. This can be done in all kinds of markets like:

  • Stocks
  • Forex
  • Crypto
  • Indices
  • Commodities

This is how shorting works (with example)

Let’s say a news item comes out that a Heineken employee pissed in the beer before it went into the bottle.

This is obviously bad news for Heineken and we expect the stock price to fall. So we want to go short. How does that work?

The moment you go short, you actually sell a share that you buy back later at a cheaper price.

That’s the world upside down! How can you sell something that you don’t have yet?

By borrowing it from your broker.

Suppose you immediately sell your borrowed Heineken share for $100. The share price then drops to $80. You must return the borrowed share to your broker, so you now buy it back for $80. You give the borrowed share back to your broker, you pay $2 for the loan and you have earned $18.

When you short, you borrow from your broker and sell it immediately. And because you repay when the loan has dropped in value, you make a profit.

Shorting is not complicated

The process of going short seems complicated, because more actions are needed than if you just buy (going long). But when on the trading platform of your broker you just have to click on the sales button.

Shorting on your trading platform, just click the SELL button
Shorting on your trading platform, just click the SELL button

The broker takes care of the borrowing and repaying. It’s all processed automatically.

Conclusion

Going long means buying and you expect the price to rise and going short means selling and you expect the price to fall. That is actually all you need to know, because the broker takes care everything else for you.

But it is always good to understand the process behind something and I hope you now understand what shorting means and how it works.

Give it a try on a demo account.

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If you have questions about how shorting works, let me know in the comments.

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