How to use shorting to your advantage

By Deputy Editor Tim Bennett Oct 17, 2008

Tim Bennett

Share with
friends:

Comments (0) Print this article

Roulette chips

Hedge your bets with a spread trade

The American authorities lifted their ban on shorting selected stocks last Wednesday. On Thursday the Dow Jones suffered its biggest one-day fall since 1987. If it joins these dots, the Securities and Exchange Commission may well be tempted to reinstate the ban. But that would be (another) mistake. Far from being some arcane, wicked practice, shorting is vital to the healthy functioning of modern financial markets. Here we explain how you can use the technique – which involves selling shares you don't already own – to improve your portfolio.

Short selling: the basics revisited

Many investors assume that the only way to make money from shares is to buy when they are cheap and sell once they have risen in price. But that's only half the story. It is just as possible – more so in today's markets – to sell expensive stocks and buy them back when they're cheap.

So, how do the professionals short stocks? A hedge fund might borrow 1,000 shares from a pension fund (which is planning on owning them for the long term) when the market price is, say, £2.50. It sells them on to someone else then waits in the hope they fall to, for instance, £1.50, before buying them back and returning them to the original lender. If it goes to plan, everyone wins. The hedge funds pockets a profit of £1,000, less fees. The pension fund banks a lending fee for the period of the loan. And other investors can take comfort from the fact that once overpriced shares are now trading at a more realistic price.

Short selling: shooting the messenger is senseless

So why the outcry regarding short sellers? After all, all they are trying to do is to bring prices down to the correct levels. If £1.50 is a more sensible price for the share, based on a firm's fundamentals, then why blame those who recognise that fact early and then do something about it? That's like criticising a mate who points out that the new car you are about to buy should be £1,000 cheaper. The car dealer will dislike him and so will anyone who overpaid the day before, but anyone he tells should be buying him a beer.

Short selling: how can you 'go short'?

Pure shorting in the manner described above is impossible for most retail investors. However, there are alternatives that are quick and relatively cheap. The first is spread betting (you can compare leading spread betting accounts here), something you can do for individual shares, sectors such as oil and gas, or whole indices, such as the FTSE 100. So a down-bet on the FTSE 100 might be placed at, say, £10 per point when the index is quoted as 4,025-4,027 and then subsequently closed when the spread has changed to 3,995-3,997. The result is a profit of 28 points (4,025-3,997), or £280.

 

Alternatively, you could buy an inverse exchange-traded fund (ETF). For example, the DB-x trackers FTSE 100 short ETF (LSE:XUKS.L) closely mirrors the inverse performance of the FTSE 100 by moving up around 1% for every 1% fall in the index and vice versa.

Short selling: why should you bother?

There are essentially three ways a private investor might use spread bets or inverse ETFs. First off, simply buying and selling shares only makes money when the market rises. So if you want a straight profit from the market falling, then shorting is the easiest way to achieve it. However there are other handy uses. Hedging is one.

If you already hold a share, or have invested in an index tracker, and you now want to protect your existing profits against short-term drops in the market, essentially you have two choices. You could just sell up now to avoid further losses. But that means you'll suffer two sets of dealing costs – to sell and then buy back your shares – plus you'll be hit for stamp duty on the repurchase and even, perhaps, capital-gains tax on the sale. A better bet might be to keep your shares and sell a spread bet on them – the profit you make if the market drops will offset the losses on your shares and vice versa, leaving you in effect neutral.

Otherwise, you could indulge in "pairs trading" – trading one share, sector or index against another. This time you are not trying to forecast which way the market will move, just how one part of it performs against another. For example, if you think company A (perhaps BT) will outperform company B (maybe Vodafone) over the next two weeks you could buy the first company with a spread bet and ask simultaneously to sell the second. Now you don't care whether the two shares rise or fall, just whether BT weathers the next two weeks in better shape than Vodafone. Or you could buy the FTSE 100 spread and sell the Dow Jones. That's a bet not about whether UK and US equity markets will rise or fall, but rather that whichever way they go, our leading shares index will do better than America, perhaps because you have greater faith in Gordon Brown's big bank bailout than in Hank Paulson's slightly more wishy-washy TARP.

Comments (0)

Published in How to invest | More articles by Tim Bennett

Share with
friends:

Related articles

Leave a comment

This will be the name displayed with your comment.

This helps us verify comments are genuine. It will not be displayed anywhere on the site and is stored confidentially.

Please keep your comment within 1,000 characters and relevant to the main topic. We encourage healthy debate, but we don't allow insults or bad language. Anything off topic or unpleasant, we'll remove. Enjoy the conversation! Thank you.

captcha To prevent spam-related comments please enter the characters shown in the 'Captcha' box to the left.

By leaving a comment you accept our terms and conditions.


>