Contracts for Difference (CFDs) are one of the few investments vehicles where loss-making companies, collapsing share prices and stocks that appear in research reports as stocks to sell, can be attractive investment opportunities.
The technique of profiting from a price fall is called short-selling, otherwise known as “shorting,” “to go short” or simply “short.” Basically, short-selling is the reverse of how we’re traditionally taught to invest, to buy at the lowest possible price and sell at the highest. When shorting, you aim to jump in at a high and out at a low – with the sequence of events also in reverse, since you sell first and buy back afterwards. Indeed, as confusing as it sounds, this involves selling something that you don’t already own.
But as far as traders are concerned, the underlying mechanics of short-selling a CFD are identical to buying, which in trading circles is called “going long”. When you short-sell a CFD, you outlay a similar deposit or margin requirement to a “long” position and pay an equivalent rate of commission. Really, the major difference between the two forms of trading is that “shorting” earns you interest on borrowed funds, whereas being on the long side of a trade involves paying interest. So provided that the CFD trade is moving in a profitable direction, you should theoretically earn more from “shorting” than “going long” a CFD trade. Finally, risk management tools such as stop losses, are undertaken in the opposite manner when you “short” compared to when you “long” a CFD. So rather than placing a “stop sell,” which automatically sells you out of your position at a designated price, when short-selling, you place a “stop buy,” which automatically buys back the CFD and closes the position out.
Most CFD providers say that you can’t call yourself a serious trader unless you know how and are willing to short sell. Essentially, the ability to trade short is something any CFD trader should aim to master. However since short-selling involves playing the market in the opposite fashion to the norm, traders must stgelop the necessary skills.
The good news for technical traders is that the indicators and signals used to spot a shorting opportunity are roughly the same as those utilised to exit a long position. For example, this may involve a downturn in the 100-day or 20-day moving average chart, representing that the share price or market is trending down.
But is it possible to score heftier profits from short-selling CFDs than taking long positions? Have you ever heard the saying “Up by the stairs, down by the elevator.” In other words, when share prices fall it can be sudden and dramatic, whereas price rises of this magnitude are much less common. So in this sense, you could say that short-selling has the potential to generate similar or even greater profits than going long, although admittedly the difficulty would be spotting the shorting opportunity before it’s too late.
Of course the trick to successful CFD trading is to spot long-term trends and trade in the appropriate direction. However, since there is a limit to how far a share price can fall, short trades should by definition be of shorter duration than “long” positions.
If anything, serious traders should at least understand and be willing to short-sell for hedging purposes. Hedging involves taking a second and opposite position in a security to offset expected losses in the first security. For instance, say you anticipate a sell-off in Telstra shares over the coming month and you hold a significant swag of them in your investment portfolio. Rather than selling your Telstra shares, paying brokerage and possibly incurring capital gains tax, you could instead short-sell CFDs over Telstra shares.
Hedging, however, isn’t restricted to just short-selling a share CFD as protection against possible losses in a physical share holding. A popular strategy for general market protection is to short-sell CFDs on local indices, such as the S&P/ASX 200 index. This is particularly handy for investors with a diversified portfolio of Australian shares. In the event that the market experienced a sudden pullback, rather than selling or reducing their share holdings, the short position on the overall index should pick up the slack.
In fact, traders can easily create their own hedging strategy based on their current investment holdings. For instance, you might short-sell CFDs on the gold price to hedge against temporary losses in your portfolio of gold stocks, or short-sell CFDs against the energy index if you are concerned about the near-term outlook of your Origin Energy shares.
Becoming an expert at the technique of short-selling also opens up a range of strategies to play the market.