Shorting and Short Selling Questions

Q. But isn't shorting complicated?

A: Shorting isn't anymore complicated than buying stocks on the cheap and selling them when they're expensive and the darlings of the investment community. Short selling is the exact same thing - only in reverse order. This follows the theory that stocks offer the worst prospects for gain when they're 'expensive', and the best when they're 'cheap' - a way to measure the dearness of stocks is through the price/earnings (P/E) ratio - 'earnings' being Wall Street's euphemism for profits.

So just as you look for ridiculously cheap valuations and an air of pessimism surrounding a stock in order to consider it for purchase, we look for ridiculously expensive valuations and extreme popularity in order to consider a stock a viable short sale candidate. Timing your entry price for a short trade is just as crucial as in buying stocks; if you short a stock at too cheap a price or get the timing wrong, then you are likely to lose money.

Q. But isn't rooting for stocks to decline in price unpatriotic?

A: This is a common misconception - there's nothing evil or unpatriotic about shorting, rather I would say that shorters make the market more efficient as they challenge the market's consensus view regarding a stock's business model or valuation. Not only does shorting makes markets more liquid but it keeps company directors alert which is a good thing. I'd argue that committing fraud, to the extent that it was performed at, for example, fund management Bernard L. Madoff in the USA or Bank of Credit and Commerce International in the UK is so much more unpatriotic than short selling. And one has to remember that that normally there is no smoke without a fire - if a stock price is falling there is usually a good reason for this and the sooner the stock or currency reaches its fair value the better. As for hoping for stocks to decline how many times have you prayed for a pullback in a share you were following to give you a better opportunity to jump in? There is one section of the investing community that argues that shorting increases market volatility but again the evidence indicates otherwise. Shorting is more risky than going long so mostly it is veteran traders who short sell - and they do so when they have good reason to believe that an asset may be overvalued.

Short selling involves selling something you don't own and because of this there are investors who feel the practice is essentially fraudulent and, thereby, unethical. However, others argue that short selling brings liquidity, truth, and transparency to the markets. The short seller, they argue, exposes malpractice - as with the financial institutions in 2008 - and forces better accountability from companies and management.

Q. Any ideas on how best to short, for somebody like me who's never done it before (apart from spread betting)?

What options are available? Just spreadbets and CFD's? And things like options and covered warrants?

A: The answer sort of depends on your tax position.

The easiest way to short is with a spreadbet. It's cheap and cheerful on fast moving bigger stocks but, of course, these can also move quite quickly against you. On smaller illiquid stocks they are very expensive, unless of course you are a 40% tax which case the extra costs melt away.

CFD's are great if you're not worried about tax but the costs are high/er if you're trading smaller amounts.

Let me give you an example.

MPH is currently 150-152 in the market. If you bought a CFD with IG the costs are £10 each way (up to 10k worth) plus the spread of two points. 1000 shares would therefore cost you £40 to open. There is no stamp duty but there is tax to pay if CGT applies.

The spread on IG for MPH was, when open, a 4p spread. £10pp to open would cost you just under £40. There is no stamp duty and no tax to pay.

In this example the cost of the spreadbet and the CFD are broadly the same.

But if you had bought £50pp/5000 MPH, the CFD would cost £120 to open, the spreadbet £200.

One other option is to open a short account with TD Waterhouse. You trade on a T10, selling short and hoping to buy back within the period. It's a high risk strategy perhaps better suited to those with a big pot and some experience. I don't hold such an account.

I've said bought here when I meant sell but it works in either direction. The only thing to add is that when you are long a CFD/daily spreadbet you pay interest, when you are short you get paid interest.

Also, covered warrants are worth looking at. My put FTSE warrants have soared in value. I was prepared to lose what I'd put into them and looked on them as insurance together with a FTSE short I have and a number of other shorts. I especially wanted to protect the pension fund and so loaded up with quite a few warrants in there. It means in the pension I can hang onto some long-term positions for now without worrying too much short-term. I am no forecaster but I wonder whether the recent July blow off is better than a long bear market where shares creep down most days.

Note: I've only used MPH because it demonstrates the difference in prices and not because I'm suggesting anyone short it. Also, I've only shown the costs of opening a trade so you can see the hurdle, there is a deposit of between 5% and 25% (broadly) to be paid as well.

Q. If I buy the shares, the worst that could happen is that I lose all my money, whereas if I short them by spread-betting for instance, the potential losses are theoretically unlimited?

A: In much the same way that not all long positions turn out to be winners, not all short positions turn out to be winners either. Hence, one has to diversify with both shorts and longs. However, being short a portfolio helps to balance the market risk of being long a portfolio. If a short of mine shoots up, and I'm confident in myself that it's nonsense, then I won't buy-back and will just carry on holding - there are plenty of cases of share prices being mysteriously 'spiked' (downwards as well as upwards) in order to encourage shorters to buy-back. These times also often coincide with a request for stock on loan to be returned to the lender often reinforcing a bear squeeze! Strange how often this coincidence occurs...and the price falls subsequently!

So YES there is a risk of unlimited losses with shorting. E.g. you short 10000 shares in ABC Pharmaceuticals when their share price is £1, with a deposit of £500. The next day, they discover the cure for cancer, and their share price explodes to £1000 per share. Not only have you lost your £500 stake, but you now owe £9,999,500 pounds. You'd hope that your supplier would terminate your bet before it got to that stage, but if the market 'gaps', there's not a lot you can do. Some spread betting providers offer 'guaranteed stop loss orders', or 'controlled risk accounts'. In such cases you pay a premium for this service, but if your spread bet loses, it is guaranteed to be terminated at a pre-arranged loss, regardless of market conditions.

Having said all this, theoretical huge potential losses are one thing but they rarely happen in practice. I have been short selling stocks for years and not once, ever, have I lost an unlimited amount of money. So in reality there is not more inherent risk in short selling than there is in buying stocks when used sensibly and with stop losses in place so that you quickly cut your losses if a position begins to go against you. Never try to rationalise that the stock will eventually come back down. Being a successful trader means having an exit discipline and sticking to it. You can always short a stock again if it begins moving down. And of course you're forgetting that during all of this time whilst shareholders are sitting on a stock going up, down and basically sideways they're not getting a dividend but I'm being paid interest!

Q. If I'm already short on FTSE daily at £2pp and I'm suddenly hyper confident that its going further down can I open another short on FTSE daily at £10pp?

A: Yes! In fact, adding to a winning position is a winning strategy (as opposed to a losing position/averaging in).

P.S. £12pp FTSE is the equivalent of selling £60,000+ worth short. Treat it with respect. Keeping my overall leverage under three as a max has helped me out no end in the last year and made me much more profitable. But I hold positions for a few weeks normally, not a day trader. For example, I'm experimenting with about £40k so try never to hold a positions with a notional value of greater than £120k.

Q. What about companies which are already heavily shorted?

For instance at this moment the top UK short positions are -:
  1. HMV - 36.3% on loan
  2. Berkeley Group - 23.34% on loan
  3. Inmarsat - 22.66% on loan
  4. Alliance & Leicester - 21.98% on loan
  5. Helphire Group 21.28% on loan
  6. EMAP - 20.07% on loan
  7. Paragon - 19.88% on loan
  8. Acambis - 19.22% on loan
  9. Bradford & Bingley - 19.18% on loan
  10. Debenhams - 18.42% on loan
What are the implications of short positions for these companies? It strikes me that short sales should be ALREADY in the price since the short position has already been sold. The holder will ultimately have to cover the short, hence MUST at some time in the future become a buyer. Doesn't that mean the long term shareprice should go back up when they ultimately buy the short position back (course, it might go up 100% from 0 - which is obviously what the shorter hopes)? Hence, the effect of shorts is to depress the near-term shareprice?

A: Yes, unless something happens, e.g. a positive trading statement which brings in buyers. The shorts then get worried and have to cover leading to a short squeeze taking the share price up a lot more than it may have gone if there had not been the forced buyers.

Shorting a heavily shorted stock is not without risk. E.g. ask anyone who has shorted uk builders before the raft of positive trading statements from Persimmon, Barret et al. All these shares have moved strongly up since these trading statements.

There is also the risk of sector rotation, so that buyers come out of shares seen in a positive light and start to come to shares that are depressed, particularly if they have a good dividend, and this too can cause heavily shorted shares to appreciate quickly.

There are likely other scenarios and of course in bear markets one often gets strong rallies that can lift the whole market and which can lead to short squeezes.

Q. Do you have any comments on what is happening with Next. It is a 'short' that is going up!

I am new to shorting, so shouldn't be showing any interest (yet that is, or perhaps was, the sentiment in the market so thought I should go with the flow). Mostly, I am currently an "unintentional buy and hold' investor and still trying to develop a method and a plan to invest medium term. Any comments/insights on why a retailer in these times is not a 'short'.

From what I can see on the negative side: various retail data - BRC, CBI all saying things down and not getting any better (but perhaps not getting any worse and there is the certainty element I guess).

Unemployment & housing appears yet to bottom. Next itself saying it continues to be a challenging market. Pre-tax profit next year down to £435 from £498. However, debt just in excess of profit at £544 and market cap 6-7 x profits.

But are the possible upsides or at least neutrals that that inflation has topped out and the next move in interest rates is likely to be down

Is a bid likely in these times of difficult financing? What I don't know is how all these various market/company facts are weighted and combine for the resulting price direction. Any education would be much appreciated. Be kind!

A: Next is not a short going up. It's a share going up! And so are all retail stocks. The notion seems to be that Fannie Mae/Freddie Mac have been saved and we are now at the bottom. That isn't to say there isn't going to be a great deal of volatility but the commentators are talking up the market.

Who knows.

As far as I can see nothing much has changed. The only thing that will help households is the falling oil price and the 10p fiasco rebate. The market seems to be rising on the basis that that will be enough to stimulate some demand and the retail sector will be saved.

The next move for interest rates is down; if oil can stay down and so that's being priced in as well. Stockmarkets should rise when interest rates fall.

I doubt many will buy Next.

Apart from that Next seems to be quite a favourite forums short, it seems to follow through from a collective memory it nearly went bust in the early 1990s, ever since I have been following the markets, every now and again a shorters party seems to form, a bit like the crusades of the Middle Ages, i.e ah we have nothing else to do, let's go and sac Jerusalem or short Next. The point I am trying to make is that over the years I have become wary of shares very popular to ramp and deramp on bulletin boards.

I hope that helps a bit. In summary; the market is currently pricing in good news that might see improved conditions for the retail sector. Whether this will hold or fold from here...well...where's my crystal ball.

Q. If you short a share via a spreadbet eg MKS (Marks & Spencer) does it make any difference to the share price of MKS?

A: I would suggest YES. The spread betting companies do exactly the same as bookmakers do. If they have a sizeable bet then they will 'lay part of it off' to cover themselves by placing a corresponding short on the market.

Q. If you short an index eg share index or commodity, does it make any difference to the underlying instrument?

A: The indices are a sum of the prices of the stocks included in the index. Placing a bet on the index cannot be 'apportioned' to one particular stock in the index so the answer has to be NO (some stocks will be doing well whilst others are performing badly).

Q. I was trying to short 3 US stocks earlier and I could only short one?

The other 2 gave a message saying there was not enough shares in the underlying market to short. This is using IG Index.

A: If you trade in the real market using direct access this happens far less often, but still does. It really depends if it's a stock which cannot be shorted or is on a hard to borrow list or if the broker just can't borrow enough to lend you.

 ...Continues here - Shorting using Guaranteed Stops

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