With the global financial markets firmly in the control of the bears, knowing how to short-sell is more vital than ever.
What is short-selling?
The initial reaction is always one of nervousness for most people and the first question is always the same: “How can you sell something you don’t own?”
There are two answers to this: the first goes along the lines of, “first, you borrow shares from your broker, …etc…”
The second, and much easier answer, goes like this: “Don’t worry about it. Just accept it’s easily done and it’s just the opposite of the process you’re used to.”
Normally, when you enter a trade you expect the share you buy will increase in value; therefore you buy those shares at a certain price and sell them at a later date (hopefully) at a higher price.
When short-selling, you actually begin the trade by selling shares you do not own in expectation of the share price falling. Then, to close out the transaction, you buy back the same amount of shares at a lower price.
So, while the concept of selling something you do not own is confusing, just remember that you have borrowed the shares from your broker.
Why would I care about short-selling?
As if the past three years haven’t given you enough reasons!
But, in general terms, there are three major reasons to consider short-selling.
First, it gives you the opportunity to profit from shares that you expect to decrease in value. This is obviously the major driver of short-selling. Importantly, this provides the trader with the opportunity to make active profits during periods of extreme bearishness (such as the current environment).
Second, you are able to hedge positions in existing shares. For example, if you own a large amount of BHP shares and want to hold them until your retirement, but are worried about what will happen over the next six months, you can use short-selling as a form of insurance.
Last, short-selling allows you to take part in more active trading strategies (such as pair trades).
How is short-selling possible?
There are two different ways of short- selling.
When using a traditional broker, you borrow the stock from your broker, who will have a process set-up with large fund managers that make a couple of extra bucks by lending out their shares.
On the broker side of the business, you are required to provide an initial outlay – often about 25% of the value of transaction as a margin or collateral.
This is held in the broker’s trust/margin account on your behalf. If the share price moves against you (as in the share price increases), the broker will require you to “top up” this account to maintain that 25% leverage ratio.
Nowadays, many traders are using CFDs (contracts of difference) to short sell or hedge their existing positions. This is because the margin is much smaller when using CFDs and the process is much more streamlined and less hassle.
So, it’s just the same as buying stocks?
No, not at all. There are a number of factors you need to be aware of when short selling stocks.
First, only certain shares can be short sold. These are included on the ASX’s approved list. You can find the approved list on the ASX’s website.
Second, even if the share you want to short-sell is on the approved list, your broker needs to be able to borrow the shares.
If they can’t get the shares, you can’t short-sell them. Selling shares you haven’t borrowed is known as ‘naked short-selling’ and is illegal.
What are the risks?
Good question! The major risk is that unlike taking long positions, in which the most you can lose is the value of your purchase, your potential losses are unlimited when taking short positions.
This is because there is no limit to how high a share can go, while on the other side it can only go to zero.
There are several other factors short- sellers need to remain aware of. Most importantly, don’t forget that you will owe any dividends paid when you have short-sold stocks – you have borrowed the shares from someone and they will still want the dividends when they’re due.
What’s it all about again?
When we “go long” or buy a share, we are hoping to buy low then sell high. The difference between the high and low price is our profit.
When we “short-sell” we are hoping to sell high then buy low. The difference between the high and low price is still our profit, it is only the sequence that has been reversed.
In practice, the vast majority of traders do not actually use the method we have described above to short-sell shares.
Most of the time, a short position can be produced through options or CFDs.
Many traders now believe that CFDs are the best way to short-sell shares. The process of using CFDs to short-sell a stock is far easier to understand than that for options.