There are a number of reasons for short selling:
If you opened a speculative short position, your intention would be to profit from a potential downturn in the market.
Speculative short selling enables traders to stay active even in bearish markets. However, trading in this way does mean assuming a high level of risk:
Your loss is theoretically unlimited.
Suppose you sell 100 shares short at a price of 1000p: your maximum profit is £1000 if the stock sinks to zero. However, if the price rises to, say, 4000p, your loss is a painful £3000 – and could keep increasing indefinitely if the stock keeps going up. There's no limit to how high the price might go, after all.
So it's important to manage your risk when short selling. We explain how to do this in the 'Planning and risk management' course.
Speculative short traders can be beneficial to the market, increasing trading volumes and liquidity. However, they can also influence market movements, even contributing to market crashes.
In 1992, George Soros speculated that sterling would fall after a prolonged period in which the British government artificially propped up its value. Weakened by short-selling pressure, including large trades by Soros, the government's policy became unsustainable. Britain withdrew from the European Exchange Rate Mechanism, causing the pound to plummet. By risking $10 billion in short positions, Soros made $1 billion overnight, and his eventual profit was nearly $2 billion.
While speculators take on risk, in contrast hedgers seek to protect themselves against it.
Taking a short position is a common strategy to offset (or 'hedge') the risk of adverse price movements in a long position you hold.
In brief, the idea is that if your long position makes a loss, your short position will make a profit to compensate.
For example, if you own a selection of stocks from the FTSE 100, you might take a short position on the FTSE index as a whole to offset potential losses should the market fall. You'll still see a drop in your share portfolio, but your short position on the index itself will help reduce the overall loss.
So a hedge is like a form of insurance. And, like any insurance, it has a cost: if your long position makes a profit, the short hedge will normally make a loss that reduces it. However, traders often feel the protection offered by the hedge makes this worthwhile.
In practice, retail traders may have difficulty finding a broker who offers short-trading services to private investors. However, you can also go short using a number of derivative products: