How does Trading work?
When you trade, you profit if the market price of your position moves in the right direction, and you lose money if the price of your position moves in the wrong direction.
The basic premise to remember is supply and demand. When there are more buyers than sellers in the market, demand is greater, and the price goes up.
If there are more sellers than buyers in the market, demand is reduced, and the price goes down.
Getting exposure to assets can only be carried out over the counter (OTC) or directly on an exchange.
Trading OTC involves two parties (trader and broker) reaching an agreement on the price to buy and sell an asset. Whereas an exchange is a highly organised marketplace where you can trade a specific type of instrument directly. For example, you can trade UK shares on the London Stock Exchange (LSE).
As you’ll come to realise, most retail traders around the world trade OTC, using derivatives like spread bets and CFDs, because the shares are more accessible than those listed on a centralised exchange.
OTC | Exchange | |
Definitions | Trading happens between two parties and often involves a dealer network | Trading happens directly on the order book of the exchange – there’s no middleman |
Locations | No central, physical location – only a virtual network of participants | Actual, physical location |
Timings | 24/7 | Specific exchange hours |
Contracts | Customised | Standardised |
Risk | Counter party risk, assets can be more volatile, and since OTC can sometimes be traded on leverage, it means there’s risk of losing more than your deposit | Higher cost, fixed hours, and you can trade on leverage in some cases (options and futures) |
Buying and Selling
As the saying goes, it takes two sides to make a market. The two sides concerned are:
- Buyers, who usually believe an asset’s value is likely to rise – known as ‘bulls’
- Sellers, who generally think an asset’s value is set to fall – known as ‘bears’
Bid and ask prices
When you look at a quote for a financial asset, you’ll generally see not one but two prices:
- Bid price – the price you’ll receive as a seller
- Ask price – the price you’ll pay as a buyer. The ask price is also known as the ‘offer price’.
Most people think about trading in just one direction. They imagine buying an asset (‘going long’) before the price begins to rise. Then they imagine selling it just as it reaches its peak to reap a profit.
While this is an excellent goal for any trader to aim for, it’s by no means the only potential way to capitalise on market movements.
Opportunities can also arise in markets that are heading for a downturn, and in this section we’ll see how you can trade these by ‘going short’ or ‘short selling’.
What is short selling?
When you go long, you open your trade by buying an asset whose value you expect to rise and close it by selling – hopefully for a higher price.
To go short, you do the opposite. You sell to open a short trade and buy to close it.
So, if you believe an asset’s price is set to fall, you might decide to sell it now in the hope of later buying it back at a lower price to make a profit.
Of course, you may logically assume that you first need to own the asset concerned in order to sell it. But in fact this isn’t the case: it’s possible to effectively borrow the asset so you can sell it short.
Why do traders go short?
There are a number of reasons for short selling:
Speculation
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.
Did you know?
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.
Hedging
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.
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.
Ways to short sell
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:
- Options
- Futures
- Spread betting (UK only)
- CFD trading