Definition of Shorting Shares: - selling securities you do not own in the hope of buying them back at a lower price in the future and pocketing the difference.
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Example
David thinks share in XYZ Plc are going to fall from their current price of 450p. He enters a contract to sell them at 450p in three months time. The price falls from 450p to 400p after three months. He buys the shares at 400p making an 11% profit (450 - 400 = 50/450). If his bet was for GBP10 per point, the profit would have been 50 x GBP10 = GBP500. With shorting, the risk is that the price moves upwards during the time period of the bet. |
In the example above if the price rose to 480p, David would have had to close his bet by buying at that price. His loss would have been 30 points (450 - 480) and, assuming that the bet was for GBP10 per point, he would be down GBP300.
In ordinary share trading, there has always been a psychological barrier to shorting. 'Selling something you do not own' was felt to be improper, almost unpatriotic, and somehow not in the spirit of investing.
If you buy a house on a Greenfield site from a property developer when all the company has at that time is a block of land and a building plan, the property developer is selling you a house that does not exist yet.
You should dismiss the thought that shorting is an unorthodox way of trading, or a kind of exotic activity reserved for hedge funds and sophisticated traders. It isn't. It is simply the reverse side of going long, and a way to back your view that a price is likely to go down. This of it this way:
- If you only ever go long on shares (buy before you sell), you can only make money from price advances.As we all know, markets can fall as well as rise, so it makes sense to be as comfortable going short on the markets as you are going long.
In spread betting, shorting is equivalent to placing a sell on a market. The way you profit is exactly the same way as when you buy. If the price falls by 10 points then your profit is 10 points multiplied by your stake.
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Example
David walks into a branch of a listed hardware company Hammer Co. and notices that there are less people lining up to buy items from the store than in previous weeks. David follows the shares of Hammer Co. and remembers that the company is due to release a trading update in a few weeks. He predicts that Hammer Co. will lower their sales targets based on his research and what he witnessed at the branch. He places a down bet at GBP10 per point at 130 p. As he rightly predicted, Hammer Co. announced weaker than expected sales over the latest quarter. The share price falls to 110p and David makes a gain of 20 points (130p - 110p) X GBP10 = GBP200. |
Definition: hedging is protecting an existing holding or asset, should it fall in value, by making an equivalent investment that offsets or reduced potential losses. This allows you to leave your share holding undisturbed in the event of an unexpected price fall.
Spread betting is often used to hedge a physical share portfolio [say within individual savings accounts (Isas) or personal equity plans (Peps)] against short-term falls in the market. It is much cheaper to do this than to sell the entire portfolio and buy it back at a later stage. Whereas hedging with physical shares incurs both stamp duty and brokerage charges, a spread bet avoids these extra costs. Whereas hedging with physical shares incurs both stamp duty and brokerage charges, a spread bet avoids these extra costs.
ExampleDavid owns a portfolio of mainly FTSE 100 shares with a total value of GBP40,740.
He thinks the FTSE 100 index is going to fall. He could back his judgement by selling his shares, waiting for the market to fall, then buying them back at the lower price. The problem for David is that he has large gainst on his portfolio, and if he sells the shares, capital gains tax charge will arise.
An alternative is to hedge his portfolio against a fall by selling the FTSE 100 index short. The idea here is that if the FTSE does fall as expected, any drop in the value of the individual shares in David's portfolio will be offset by profits he makes by going short on the index. Let's say that David takes the spread betting route and see what the effect would be:
Action: He sells GBP10 per point of the FTSE 100 future at 4074 points, when the quote on the index is 4074 - 4080.
Scenario 1: The FTSE drops by 10% to 3666Assuming that David's individual shares all fell by the same % as the index, his portfolio would drop in value by GBP4,074 to GBP36,666
- If David closes his spread bet by buying the FTSE 100 Future at 3,666, his gain would be (4074 - 3666) X GBP10 = GBP4,080.
In other words, his portfolio losses would be matched by profits from his short position.
Scenario 2: The FTSE does not drop, but stays at 4074- If the FTSE does not fall as David expects, buy stays at 4074, and assuming that his individual shares reflect the index, his share portolio would be unchanged in value at GBP40,740.
- When David comes to close his short position by buying back the FTSE 100 Future he will have to do so at the higher side of the spread let's say 4080. His loss of the spread bet will be limited to the spread of 6 points X GBP10 = GBP60.
Scenario 3: The FTSE does not drop, but rises to 4150- If David's prediction is completely wrong and the FTSE rises to 4150, his share portfolio will rise in value in proportion to a value of GBP41,500.
- His losses on the spread bet will be approximately the same. He will have to buy back the FTSE at 4150, and will make a loss of GBP760 - GBP10 per point on the difference between 4150 and 4076.
There are several key points to note about this hedge:
When something is described as gathering momentum, the image of a snowball gorwing larger as it rolls downhill comes to mind.
In the share market, momentum trading works in the same vein. A trader will either buy or sell on a market when there appears to be more activity (on the buy or sell side), other traders follow suit and it becomes a self-feeding mechanism.
The key to momentum trading is finding out trading volumes, the actual number of those buying and those selling, and in what amounts. Traders can find out this information if they have access to what is called Level II data. This date is the entire breadth of information available from the stock exchange. These days, private investors can afford to subscribe to Level II services.
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Example
Clothing retailer New Look Plc is quotes in the market at 334 - 338. Over the past two hours, most of the volume is changing hands at 338p. A momentum trader would take this as a buy signal. The view is that because most trades are buy trades, the share is going to go up. |
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Example
Similarly, when looking at the order book (Level II data)) of a share, there may be tell signs that a particular share is going up or down. The screen below shows the order book for shares in telecommunications equipment maker Marconi Plc. You can see that there are more buyers than sellers at this particular time. More specifically, there are 89,873 shares on the bid or sell side and only 7,700 share on the offer or buy side - this would be a buy signal for a momentum trader. |
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A pairs trader or a hedge trade is one in which you go long on one share and short on another in the same sector. By placing a long bet on one share while taking an equal and opposite short bet on a related share, you are simply betting on the differential between those two securities, rather than the direction of the overall market. The theory is that as both of the share are in the same sector, they will move in the same direction (up or down). However, if one company is perceived as stronger than another, then the stronger company enjoys a higher price rise than the weaker company.
For example, let's take the telecommunications sector and assume that the market is bullish about its prospects. Suppose we pick two companies in the sector, Cable ABC Plc and Cable XYZ Plc. If Cable ABC Plc has posted rising profits over the last three years while Cable XYZ Plc posted a profit warning only two months ago, then we can safely say that Cable ABC Plc is the stronger company.
Definition: selling securities you do not own in the hope of buying them back at a lower price in the future and pocketing the difference.
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Example
Action: You place an up bet on Cable ABC Plc and a down bet on Cable XYZ Plc. Scenario 1: The telecommunications sector enjoys a re-rating. Shares in both Cable ABC Plc and XYZ Plc go up. More specifically, share in Cable Plc rise by 10% while shares in Cable XYZ Plc rise by 3%. Result: Profit gain from Cable ABC Plc compensate for losses in the down bet for Cable XYZ Plc. Scenario 2: The telecommunications sector enjoys a re-rating. Share in both Cable ABC Plc and Cable XYZ Plc go up. More specifically, share in Cable ABC Plc rise by 10% while share in Cable XYZ Plc rise by 10% Result:Break even Scenario 3: The telecommunications sector does not enjoy a re-rating but contrary to expectations suffers a de-rating. Shares in both Cable ABC Plc and Cable XYZ Plc go down. More specifically, share in Cable ABC Plc fall by 10% while shares in Cable XYZ Plc fall by 15%. Result: Profit gain from the down bet on Cable XYZ Plc compensate for losses in the up bet for Cable ABC Plc. |
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Example
Opinion: David decides in November 2002 that Nokia was overpriced in its sector. Action: He placed a sell bet in Nokia and a buy in Ericsson, hoping that Nokia would fall and Ericsson would rise. By placing a pairs trade, he was not directly exposed to overall market risk because he was effectively hedged. If the sector fell, he would make profits on Nokia and lose on Ericsson. Result: The pairs trade was a success. Nokia fell from 1700 to 1420 and Ericsson rose from 1300 to 1730 over the year. |
| Example Instead of betting on two companies in the same sector a pairs trader can also be done on two companies from differenct sectors. For example, one from a cyclical sector and another from an anti-cyclical sector. In particular, one stock is in retailing and the other is a utility. |
In pairs trading, the aim is to profit from one share outperforming the other.
Spread betting companies set their own quotes and this can lead to one quoting a more favourable bid-offer price than another for the same product. This provides "arbitrage opportunities" where traders pocket the difference by buying one quote and selling the other.
Online trading has made it easier to compare quotes from different providers so arbitrage opportunities are few and far between. It is not a recommended exercise for novices.Still new to spread betting and want to read more? - get a free copy of Michelle Baltazar's book by applying for a ETX Capital Account by clicking here This book a offers a decent overview of spread betting (even if basic) and the ETX Capital simulator account should prove useful for experimenting.