Short selling won’t make you popular but the profits can be enormous

If you fear a fall in equity prices, you could consider going short – but it’s not for the fainthearted

Short sellers bet that markets will fall, rather than rise. Photograph: Torsten Blackwood/AFP/Getty Images

Short sellers bet that markets will fall, rather than rise. Photograph: Torsten Blackwood/AFP/Getty Images

 

If you feel, like some commentators do, that “irrational exuberance” is back in the markets, you may fear a fall in equity prices. Or you maybe you feel that dollars or sterling have strengthened too much, or that some commodity is ready for a fall.

But, rather than pulling your money out of the markets entirely, you could take a different approach on your investments. You could go short.

In essence, this means taking a bet that markets will fall, rather than rise.

To benefit from such a movement, you need to agree to sell a stock (which you don’t own) at a certain price in the future, on the expectation that its price will fall. If it does, you can buy the stock at that later date at a cheaper price, sell it on for the agreed former price, and pocket the difference. The profits can be enormous. Hedge fund manager John Paulson, for example, famously made about $3 billion to $4 billion when he predicted the subprime crisis and went short on the US housing market, while another famed short seller, George Soros, profited by $1 billion in just one day when he shorted sterling and “broke” the Bank of England. The downside is that if the price of the stock doesn’t fall, you could be sitting on some serious losses.

Don’t expect to be popular

Short sellers are typically not the most popular kids in the class, because they’re taking positions that require a stock to fall in order for them to make a profit. In effect they’re saying, “We think your shares are overvalued and they’re going to fall.”

But many argue that short selling is a legitimate strategy, and without it, it can be hard to make profits when markets are falling.

At the peak of the crisis, in 2008, the Central Bank of Ireland prohibited short selling on Irish listed stocks, along with regulators across the world, and chief executives of banks ranging from Lehman Brothers, to Morgan Stanley and HBOS, to Anglo Irish Bank blamed short sellers for their woes. We now know short sellers simply identified the problems in the banking sector before everyone else did.

Indeed famed short seller Jim Chanos has said the most important function fundamental short sellers bring to the market, “is that they are real-time financial detectives”.

How can I go short?

You can short a stock or a market in a number of ways and the options are endless, from stocks to indices to commodities. “You can more or less short everything,” says Peter Brown, cofounder of the Institute of Investing & Financial Trading.

ETX Capital, a spread betting and CFD (contracts for difference) specialist, has about 6,000 products on its platform, most of which can be shorted.

One stock that’s difficult to short, however, is AIB. Given the stock’s unusual valuation, Des Doyle, country manager of ETX Capital, says they frequently get calls from investors looking to short it, but to short the stock, you have to pay a hefty borrowing charge of about 17 per cent a year, which can take away any advantage.

One use of short selling is to hedge long positions you may hold. For example, if you own a number of stocks on one index, if you take out a derivative contract to hold a short position on the entire index, you can protect your portfolio.

“A lot of clients who are long equities but have concerns about the markets utilise ourselves to hedge their long exposure,” he says. This means someone with €100,000 in exposure to US equities might short the S&P index for 25 per cent of that, for example.

“It’s not everyone’s cup of tea, but it can be quite sensible, if you’re long five stocks and short one,” he says.

A short trade can be achieved in a number of ways. Firstly, you can ring your local stockbroker who will borrow the stock, often from a pension fund. Pension funds are typically a major lender of stock, as it allows them to make income on their long term investments.

This can be one of the more expensive routes to take, as the broker will have to borrow the stock and will charge you interest and commission on that. In addition, borrowing fees can be steep when there is little stock to borrow.

To keep costs in check, Brown suggests using platform technology. “It’s the most efficient way if it’s a short-term trade,” he says.

If it’s a foreign-currency trade, such as for a UK or US stock, a foreign-exchange charge of between 0.6 per cent to 1.5 per cent will also apply.

What are the risks?

Shorting is not for the fainthearted or the uneducated. When you go long on a stock, the downside is limited to the potential collapse in value of the stock. When you’re on the other side of the trade, there is no limit to the amount you can lose, as the value of the stock can keep on rising.

What’s a stop loss?

Given the risks, short traders often add a stop-loss to their position to limit the downside risk.

Put simply, this is an instruction to trade when the price of a market reaches a particular level, and allows you to exit a short trade if the market is moving against you, before you incur hefty losses.

Consider the example of good news coming out about a company during – maybe it’s been taken over or maybe it got regulatory approval for a new drug, for example.

But as it’s out of hours you can’t access a price, so by the time markets open the next morning the share price might be up 20 per cent and you might have lost significantly. “But you can’t do anything about it,” says Browne.

To manage your risk, you could opt for a stop-loss which will sell out of your trade if the share goes up by more than 5 per cent, for example. As with all types of insurance, you will pay a premium for this.

Are short positions disclosed?

Under new European rules, investors have to tell regulators when they have a net short position worth more than 0.2 per cent of the company. Once this exceeds 0.5 per cent, the regulator then makes this public, as shown in the table above.

What about spread betting?

Another option to implement a short strategy is via spread betting. Again, the technique comes with warnings, as the downside can be limitless. In essence, spread betting involves making a bet on the direction a stock or market will take. You don’t hold the underlying asset, so you are not liable to stamp duty or capital gains tax.

As with CFDs, spread betting is leveraged, which means you need to lodge only a certain amount. “The easiest way to place a bet on the market either up or down is spread betting, as there’s no capital gains tax and no stamp duty,” says Brown.

What about CFDs?

Contracts for difference (CFDs) got a bad reputation postcrisis and for a good reason: investors – or speculators might be a more apt word – used the product to leverage their positions, and took on risks that were too large.

CFDs have a purpose in the market if used appropriately. ETX Capital, a UK financial company with an office in Dublin, recently estimated that between about 50,000-75,000 people in Ireland trade CFDs.

“The appetite for leverage isn’t as high; people are starting to realise that they can utilise these derivatives as an add-on to their portfolio,” says Doyle.

Browne agrees CFDs can be an efficient way of shorting. “They’re a very nice way of getting access to the market without having to put all the capital up,” he says. For example, you could put €20,000 of a €100,000 bet into a CFD, keep €10,000 on the side to cover movements, and keep the €70,000 earning interest.

But tread carefully.

“If you’re using it to leverage yourself into the market, it’s an extraordinarily dangerous thing to do,” says Browne.

If you’re wondering whether to opt for a CFD or to spread bet your trade, tax might help you make your decision.

“If you have a high conviction of your trade going your way, there are simple tax advantages to it. But if you’re slightly concerned go for a CFD,” says Doyle, adding that you will then be able to offset the losses on a CFD against any future gains.

Short selling: How does it work? Company XYZ is currently trading at $21.24 per share. You decide to short-sell 1,000 shares of it for a total of $21,240.

Shortly afterwards, disappointing half-year profits cause the share price of Company XYZ to fall to $20.74.

You can now buy 1,000 shares of the company for $20,740. You then return the shares to the lender, who accepts the return of the same number of shares as they lent, irrespective of the fact that the market value of the shares has decreased.

You retain the $500 difference (minus borrowing fees/ commission) between the price at which you sold the borrowed shares and the lower price at which you bought them back.

When it goes wrong . . . ABC is trading in the market at £1.50. You decide to short-sell 2,000 ABC shares for £3,000 (2,000 shares x £1.50 per share).

Shortly afterwards, the price of ABC rises to £1.65. You need to close out to meet your obligation to the lender by returning the same number of shares. You buy 2,000 shares of ABC for £3,300 (2,000 x £1.65). Your broker then returns these to the lender, who accepts the same quantity of shares.

You’ve made a loss of £300 (excluding borrowing fees/commission), which is the difference between the price at which you sold the shares and the higher price at which you bought them back.

Source: IG Index

Irish stocks: Who is shorting them? Investor: JP Morgan Asset Management Stock: C&C Net short: 0.47% When: May 6th, 2015

Investor: Henderson Global Investors Stock: Paddy Power Net short: 0.46% When: April 29th, 2015

Investor: Odey Asset Management Stock: Bank of Ireland Net short: 0.74% When: April 28th, 2015

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