Handled carefully, shorting can be useful

Not every company can be a winner. There will be those in shrinking industries, such as high street retail, or those that have been badly run, or subject to fraud. Every year, companies go bust, or fall into terminal decline. The same is true for other asset classes: currencies slide as governments build up debt while commodities are subject to waning demand.

Introducing shorting

For the most part, all investors do when they find these weak spots is to ignore them, focusing instead on stocks or commodities where the price is likely to improve. However, ‘shorting’ offers traders the chance to make money on falling asset prices and can be an important weapon in their armory.

There are plenty of reasons why shorting can be a useful tool: first and foremost, it allows investors to make full use of all their ideas – both positive and negative. It can also be used as a tool to hedge a position or take a more nuanced view on markets.

The mechanics of shorting

There are various ways to profit from falling asset prices. The conventional way to short a stock is to borrow the shares from a broker. The trader then sells the shares and buys them back at a future date. If the shares have fallen, the trader will have sold them at, for example, £10 and then bought them back two months later at £8 - a £2 profit.

Most brokers will charge borrowing fees as well as any dividends paid by the borrowed stock. As such, it can be more expensive to go short than buying a ‘long’ position. At the same time the broker may charge margin if the position goes against you.

Another option – more common today – is to use leveraged trading, particularly contracts for difference (CFD)trading. In leveraged trading, investors don’t own the stock, they just trade the difference in price. They place a bet on the direction they believe the stock will move. This can be a cheaper way to short stocks, but the inherent leverage can magnify risks.

Why do it?

While looking for winning stocks, currencies or commodities, there will often be another side to the trade. Industries subject to significant disruption will throw up rapid winners, but there may be incumbent businesses likely to lose out. Shorting is a good way to ensure these ideas don’t go to waste. If you get it right, it can be hugely profitable and bring much-needed diversification to your portfolio.

Equally, shorting can be a useful tool to hedge risk or finesse exposure. For example, if an investor wants to bet that one oil company is better than another, they may go long on one company and short another within the same sector. That way, rather than getting residual exposure to the oil sector, they only get exposure to the performance of the specific company.

And why not?

The problem with any short-selling is that share prices have unlimited upside – in theory at least. In contrast, they can only go to zero. As such, every short seller has unlimited downside and limited upside, which – as any good trader knows – is the wrong way round.

There is also the problem that markets, on the whole, tend to rise, so investors are battling the beta of the market. It may be that the company is still paying dividends and it can be more expensive and complex to short stocks. This isn’t an argument against short selling, but it does mean the short seller has a natural tailwind and therefore needs to be more cautious.

Those trading on margin or with leverage face all the usual problems associated with this type of trading. Losses can be magnified; you may get margin calls; and, as the famous economist John Maynard Keynes once said, “the markets can remain irrational longer than you can remain solvent”.

Market awareness plays an important role

Short sellers always need to be wary of merger and acquisition activity. One famous case study was Volkswagen in 2008. Widely shorted, it was subject to a surprise takeover by Porsche, leading to, as one analyst put it, “the mother of all short squeezes”. Its share price bounced up and it briefly became the world’s biggest company by market value. Traders who had sold borrowed shares had to scramble (and pay high prices) to buy shares back and close their positions.

Equally, before any short-selling it is worth checking the volume of short-sellers on a stock to see if everyone has had the same idea – if they have, the weakness may be in the price already.

Short selling can be a useful addition to a trader’s toolkit. However, it can also be a quick way to lose money. It needs to be used with care.

The Fineco trading platform offers a range of options, including leveraged trading, across 26 global markets using one multicurrency account and transparent, competitive pricing.