Going short: Short selling to make a profit
Wednesday, 24 September 2008 06:19
Last week in what seemed like a bid to stop the world's financial system going under, the UK's financial regulator, the Financial Services Authority (FSA), banned short-selling on financial stocks to call a halt to turmoil hitting banks.
While the big hedge funds were blamed for bringing down banks' share prices and gaining by short selling, it is not something out of reach of the every day investor.
Nor is it an underhand way of making cash. The head of the FSA described short selling as a "legitimate market practice".
What is short-selling
Media reports often describe short selling as betting on the price of a stock going down - and the upshot of going short is pretty much that, although it is a little more complex.
In standard market trades, investors hope to buy a stock, see it go up in price and sell it to make a profit. This is known as going long. Short selling, however, allows investors to make a gain while stocks are falling in price.
If a trader thinks a stock is overpriced, then it makes sense to go short as he expects the price to fall.
When going short, a trader is selling a stock he doesn't own but is promising to deliver it later. So he borrows a stock at a certain price and sells it. When the price falls, he buys it back at the lower price and returns the share.
Darren Winters, founder of investment WIN Investing, the leading stock market investment training company explains: "Let's say you borrowed and sold shares in a firm at the beginning of the month at 348p.
"You wait for four weeks then, after the price has dropped to 248p, you buy back the stock at that price. You will have made a profit of 100p per share. You then give the shares back to the original owner from who you borrowed them, plus a little bit of interest which is classified as 'borrowing costs'.
"The rest of the difference is all profit for you."
He adds: "The process might sound complicated, but it's quite automatic once you got authorisation from your broker that you can short sell stocks, and that they have shares in whichever stock you are interested in trading."
Shorting may sound simple, but as with any investments there is the risk of things going wrong. If you borrow the shares and they then rise in price, you will be out of pocket and be forced to make up the difference when returning them.
As with any investment, you have to decide how much risk you are willing to accept.
Mr Winters advises traders going short to act quickly if the markets are going against them.
"Don't let a short-term trade turn into a long term trade by hanging on to it too long while waiting for it to go down. Admit to yourself that you were wrong about that share and close the trade immediately.
"Manage your risk very closely and aggressively."
He also advises only shorting in a bear market.
"Shorting stocks in a bear market increases your probability of success so try not to short stocks in a rising bull market!" he adds.
Pros and cons of shorting
The Association of Private Investment Managers and Stockbrokers (APIMS) explains defenders of short selling see it as "a necessary, indeed desirable, feature of the market".
Shorting also provides liquidity and accelerating price corrections in over-valued stocks. As such, some believe that short sellers can act to stabilise prices in a declining market.
However, critics of the practice point out short selling can also increase share price volatility - and exaggerate price movements.
In the cases of HBOS and Lehman Brothers, it is claimed shorting depressed the bank's share price so much it undermined commercial confidence.
Selwyn Parker - author of The Great Crash - sees large scale shorting as we have seen as "pernicious".
"I don't think we have any idea of the extent of short-selling. The odd thing is look at Lehmans. It was bankrupt on Monday but had more assets than liabilities.
"Why would it go bankrupt? Because its share price is coming down.
"You have obviously got this pernicious behaviour in the market. Even though the business is sound, the share price is being driven down. Why is that? To me it means the short sellers are dominating the rational investors."
Finding a stock worth shorting
When looking at shorting don't just speak to a broker and demand to go short. It takes time and research to identify firms that are overvalued and could see their stock prices fall. In the City, analysts work hard establishing the outlook of firms, so it could be more than an afternoon's work.
However, there are some trends to look out for, such as rapid decelerating sales and earnings/profits growth, both on a year over year and quarter over quarter basis, although usually a market should pick up on this. But sometimes firms see gains from being part of a particular sector, when really their outlook is not so positive.
Companies where the original concept or model for the business or major product is broken, is in decline or going out of date, such a technology-based product where new technology is starting to replace it, could also be a candidate for shorting.
Mr Winters also advises investors to look out for big merger and acquisition announcements by companies that are ego-driven at the top end of the market.
"Watch these acquisitions, for they tend to over extend the companies and management do these deals because of their big egos and not to enhance shareholder value. RBS's ABM Amro acquisition is an example, as well as Vodafone's acquisitions in the late nineties and early 2000s."
However, hindsight is useful in these occasions and the markets are strewn with lost millions from traders who mistakenly named the top or bottom of the market.
Alternatives to shorting
With the FSA banning short selling on financial stocks, there are still some options open of those willing to risk their money on banks falling further.
Spreadbetting allows investors to bet on a stock falling - although the majority of those who do bet on the stock markets bet on rises rather than falls.
It is also possible to take fixed odds bets on stocks rising or falling.
Ryan Kneale, chief market analyst at BetsForTraders.com, explains: "Thanks to the FSA ban, fixed-odds financial betting overnight became the only way of shorting a bank and it was inevitable that traders would find this loophole as they scrambled to get around these protectionist rules."
He adds betting does not include any contracts or buying or selling of the actual shares, and therefore is not subject to the FSA's ruling which applies to spread betting companies and brokerage houses.
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