Short selling and leverage go hand in hand and in this article, I will teach you all there is to know about how short selling works and why borrowed money plays such a big part in this style of trading.
The idea of short selling can be complicated for beginner traders but I am going to try to explain it in a way that everyone can understand.
The important thing to remember from this guide is that short selling is always done with borrowed money, but more on this later.
Key takeaways
- Shorting a stock, a forex pair, or a cryptocurrency has to be done through a margin account where leverage is provided by your broker to sell contracts to the marketplace.
- Short selling works by first borrowing contracts from your broker, then selling these contracts to another trader (or market maker), and then buying them back later at a lower price at a profit.
- It is not possible to initiate a short position without margin simply because there are no contracts to sell. Short selling without borrowed contracts would mean that you simply sell what you already own and that is the same as dumping your holdings. The process of shorting a position happens automatically on behalf of your broker.
How short selling with leverage works
Short selling and leverage work together by combining borrowed money and the possibility of betting on a falling market.
Every time you open a short position, in any asset class or market, borrowed money, or credit, is needed.
Credit is the borrowed money, or borrowed contracts, that you receive from your broker which can be used at different ratios.
These borrowed contracts can be sold to the market through a short position which is a speculative bet in a negative direction.
If the market falls after you open a short position, you earn a profit, and if the market rises, you lose.
Once you click the Short button on your crypto leverage trading platform or forex broker you are borrowing contracts from the broker and selling them to a counterparty (another trader or a market maker).
Tip: You can use our short selling calculator to calculate your profit, loss, and position size when shorting with leverage.
This happens automatically and without any extra fees other than the leveraged trading fee that your broker charges for opening and closing a trade.
Suppose you are a cryptocurrency trader and you believe that the overall market is going to fall during the next couple of weeks due to elevated prices.
You decide to open an account with a crypto exchange to get the option to short-sell coins.
Your bet is going to be a short position in Bitcoin at a margin ratio of 1:25 and your initial investment is $800.
This would mean that your total exposure in the market would be at a value of $20,000 in a short position.
Now, after 2 weeks the market has fallen -22% and you have profited a total amount of $4400.
This money is yours after you buy back your short position.
Can you short sell without leverage?
It is not possible to short sell without a margin account through the use of a broker.
Each time you open a short position you are borrowing money that you don’t own to either buy or short a Stock, a Forex pair, or a cryptocurrency.
This is why every short position requires margin to function.
Without the use of added purchasing power, there would be no contracts to sell back to the market since you don’t own them yourself.
This is why every short trade is done through either a Forex broker, a Stockbroker, or a Cryptocurrency exchange, all of them offer contracts to short sell their assets.
It is not possible to short sell on a spot exchange or a stock exchange that doesn’t offer margin-traded contracts.
What does short selling mean?
Short selling means that you open a position that profits from a falling market or a price decrease.
A short position is a borrowed contract that gives you the possibility to sell a stock, a forex pair, or a cryptocurrency to another trader as a bet on falling prices.
Short selling is always accompanied by the use of credit which is when your trading platform borrows your money, or contracts, to either increase your position size, or in this case, short sell.
Short selling is counterproductive to what most traditional investors have learned where you buy a stock in hopes that it will increase in price over time.
Short sellers benefit from falling prices.
For example, Bob invests $5000 in his stock trading account and he thinks that Tesla is overvalued and will fall in price during the coming month.
Bob’s stock broker offers credit and the option to short sell.
So, Bob decides to open a short position that requires a ratio of at least 1:1.
3 weeks later Tesla has fallen -15% in value and Bob collects a handsome profit of $750.
This is one example of how long-term investors profit from leveraged investing, however, it can be done in a short timeframe as well.
The concept of multiplying your capital explained
The concept of leverage in trading works by borrowing money from your broker to multiply your position size by a certain ratio to increase the potential for profit and loss.
Borrowed capital cannot be used without collateral and therefore you need to make an initial deposit.
Once you open a position you will be exposed to the market with an increased trade value and once you close the position the leverage has to be paid back to the broker.
Credit is most often used by short-term traders to support an underfunded by increasing the buying power.
Before you open a trade you are asked to choose a ratio which will be the amount of capital you borrow from the trading platform.
Overall, borrowed capital can be a good substitute for a small account or for an active day trader who relies on small price movements to make quick gains.
How to short sell
To short sell any asset class, you first need to find a broker or trading platform that offers margin accounts or contracts that allow you to short the market.
These contracts are usually called futures, derivatives, options, CFDs, or spread betting.
Related: Spread betting leverage
Short selling is very simple and can be done by any amateur as long as the option is available through your broker.
It works very similarly to buying a stock, a currency pair, or a cryptocurrency.
Below is an image showing you how to short sell on a crypto broker.
The yellow square indicates the short sell button which works the same way as the buy button.
The top arrow indicates the credit level chosen for this short position, in this case, the leverage ratio is 100x.
By clicking the Short button, you open your short position.
You can later close out your position at any time.
Long position vs short position
What is the difference between a long position and a short position you may ask?
The only difference is the direction of the trade and what type of broker offers the position.
- Long position = A long position is a trade in the positive direction that aims at generating a profit by increasing prices. Long positions are offered by every broker.
- Short position = A short position is a trade in the negative direction that earns a profit when the price falls. Short positions are only offered by a broker.
A long position is the standard position in traditional finance and in trading in general which is used to invest in an asset class by buying the underlying security.
Short positions on the other hand are contradictive and are used only when the speculator thinks that the price of an asset will fall.
Short positions can only be used when margin is offered and can not be used in the spot market.
This is one of the differences between spot trading and leverage trading.
How much leverage is required to short sell?
The minimum amount of credit required to short sell is at least a ratio of 1:1 but it has to be done through a trading platform.
A leverage ratio of 1:1 means that you are trading the same size as your current account balance.
However, trading through a margin account allows you to borrow contracts and sell them to a counterparty.
This option is not available through a standard spot market.
The minimum amount of added funds can sometimes vary depending on what type of broker you use.
On some occasions, some forex brokers will have a built-in ratio of for example 1:100 or 1:200 which you are forced to use.
In this case, you need to be aware of the risks that come with shorting on high ratios.
How much money is needed in the end?
The minimum amount of money required to enter a short position depends on the minimum lot size of your broker which can vary between $10 to a few thousand dollars.
Some forex brokers offer micro lots which have a minimum position value of $1000.
Other crypto exchanges have lower margin requirements and only ask for a minimum deposit of $10.
Some stock brokers that offer CFD trading can sometimes require even less money to initiate a short position.
If you short sell a stock through a traditional stock exchange it is common to see requirements such as 50% collateral or 25% collateral on the total value you want to short.
This collateral money is taken from your account balance.
At which ratios do traders typically short sell?
Is credit the same as shorting?
No, it is not, however, short selling can be done with both high ratios and low ratios.
A high ratio is riskier and reduces the distance to your liquidation price while a lower ratio is considered safer.
You can check your liquidation price by using our liquidation price calculator.
For example, some traders prefer to short sell with a low ratio of 1:5 while others are more aggressive and choose a ratio of 1:100 or more.
This is completely up to each trader.
Our guide on selecting the correct ratio for beginners explains in detail how to choose the optimal ratio if you are a new trader.
Some examples to give a clear picture
This is an example of the process when short selling.
Suppose you want to short the Microsoft stock through a CFD broker and you want to use a ratio of 1:55.
First, you need to make an initial deposit using your credit card or bank account.
Let’s say that you deposit $600.
This account balance combined with a margin ratio of 1:55 will give you a total purchasing power worth $33,000.
Once your account is funded you can go ahead to navigate to the trading platform.
Inside the trading platform, you will find the Short Sell button next to the Buy button.
Select your chosen ratio and the trade volume you want to use.
Now click Short sell.
That’s it. From here you can follow your open position the same way as you do with a buy position.
To close the trade, click cancel position, and your trade will be canceled.
My benefits and downsides
There are of course some benefits and downsides when shorting. Here are some general pros and cons of short selling with leverage that I think every beginner trader will encounter.
Benefits:
- Increased profits
- Short selling gives you the option to hedge your positions
- Possibility to speculate on falling prices
- Adds flexibility to your trading strategy
Downsides:
- Potential unlimited loss
- Risk of liquidation through leverage
- Can be difficult to understand at first
- Increased fees
If you do decide to short sell with leverage I recommend that you read our guide on leveraged trading tips where we go through 36 tips that every beginner and advanced trader should learn.
