There are ways to short the market through traditional trading, for example using contracts for difference (CFD) - but investors will usually rack up commission costs by doing so. And if they make a profit on a CFD, trader will then be liable to capital gains tax (CGT) on the proceeds.
Spread betting, on the other hand, is tax-free, and a type of spread bet known as a rolling spread is very similar to a CFD. But the flipside of not having any CGT charge attached is that spread betting customers cannot use any losses they suffer to offset gains made on other investments when it comes to calculating their overall tax bill.
But I ask, in this major slide in the market: Where have you been? We are living in one of the best opportunities to make money on the downside yet still few have taken advantage of this. I urge you to at least consider shorting as an option as you could surprise yourself and experience that sense of achievement of making money in a falling market.
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Shorting the market has become highly topical since the great 1990s bull run not only petered out but also retraced to the point where the average private trader's portfolio had lost money. During my 15 years in trading futures, options and stock derivatives using technical analysis, it has always been apparent that the majority (estimate 80%) of 'retail active traders' are not comfortable being short. Shorting is not a natural psyche per se. Traditionally, we have been used to buying and adding to positions as markets' bias is up. Even after major bubble bursts - e.g., 1987 they still head higher. Well, they have in the past...
However, in our current environment of becalmed ranges in one day followed by sporadic volatility the next, it is highly improbable that being a long-only trader will win the day. There is only one answer: become comfortable with shorting the market, consider shorting as frequently as buying and use it in your armoury of frequent trading strategies, irrespective of market conditions. Studies also how that three-quarters of all stocks follow the broad market trend. That obviously puts the percentages on your side during a bear market. Remember, that while investors get attached to shares, it is psychologically easier to kill a losing short, we all tend to remain stubbornly hopeful about our long positions even when they are underwater.
Some basic statistics based from my own experience: markets really only trend 10% of the time; these trends can be down as well as up; stocks spend about two thirds of the time moving higher and one third of the time moving lower, also markets fall three times faster than they rally. As an old investor once told me, 'shares go up by the stairs but come down by the lifts'. If you look at the UK house builders they had a great up move from 2000 to 2007, but if you look at the fall from the middle 2007/2008, the fall has been faster than the rise. Want more evidence? Just look at the FTSE, in 2008 FTSE opened at 6456 but closed the year at 4423. That's 31.5% down in a year. Bearish markets tend to emphasise this and down movements are more likely to be long and extended while rallies tend to encounter resistance and any upward strength is likely dissipate quickly. When the down-moves happen faster than the moves higher it's a sign that the market is accelerating to the downside (as investors panic...)
Did you know? It is called shorting because the practice revolves around selling a security that a speculator does not own and has to borrow first. For this reason, while the short position is opened, a 'short seller' is short of the security towards the subject who lent him the security.
Some basic statistics based from my own experience: markets really only trend 10% of the time; these trends can be down as well as up; markets fall three times faster than they rally. As an old investor once told me, 'shares go up by the stairs but come down by the lifts'. If you look at the UK house builders they had a great up move from 2000 to 2007, but if you look at the fall from the middle 2007/2008 fall has been faster than the rise. Bearish markets tend to emphasise this and down movements are more likely to be long and extended while rallies tend to encounter resistance and any upward strength is likely dissipate quickly. When the down-moves happen faster than the moves higher it's a sign that the market is accelerating to the downside (as investors panic...)
Fact. You can make money shorting in a bull market as readily as making money buying in a bear market. It is about understanding the market dynamics, your timing, your exposure and your calculated risk. I have known many successful contrarian traders whose sole aim is to buck the trend to exploit market turning points and weaknesses.
Shorting shares is certainly not for the novice investor, but it offers a new world of opportunities for the more experienced investor. Short sellers such as Evil Knievil borrow shares from a broker, then sell them on to another buyer. The proceeds are then transferred to the shorter's account. The shorter must buy back that stock at some point in the future to give back to the broker. Obviously, the shorter expects the shares to fall and aims to buy the stock back at a lower price and trouser the difference. It's all quite simple really.
The reason why shorting has been regarded as belonging to the realm of more experienced investors is that, in theory, you have unlimited downside. While it is true that losses could be significant, the 'unlimited' moniker is ludicrous. If losses are unlimited in shorting, then that means the share price can also rise to infinity. That is clearly nonsense. You can assess the upside potential in most companies, and there is always a ceiling that can be assessed. No share price will ever rise to infinity, so there is no such thing as "unlimited" losses.
Another danger of short selling is a "short squeeze". This occurs when there are a large number of short positions in the market on a particular stock. There may be a piece of good news, such as a better-than-expected earnings report, which causes a rally in the shares. People with short positions would then want to limit their losses and buy stock. This causes a run on the shares, which sends them even higher. It is always best to try to avoid shorting stocks where there are a large number of short positions. Not only is a short squeeze possible, but if it is known that there are many short positions on a particular company's stock, then large market players can manipulate this to their advantage. Large players with deep pockets can go on a buying spree that has nothing to do with their view on whether or not a company is an attractive proposition. This forces the price of the shares higher. Shorts are then forced to close their positions, creating a short squeeze and boosting its long position further. You can divide the short interest by the total average daily volume to determine how many days it would take for all the short sellers to completely buy back, or cover, their short sales. This 'days to cover' figure is useful in gauging how susceptible a stock may be to a short covering rally. So it is generally not a good idea to short sell stocks that are already heavily shorted, as it is not a good idea to buy companies that already lots of people are bullish on...
Investors can short stocks by trading contracts for difference (CFDs), or by financial spread betting. Any profits from CFDs have tight spreads, but are subject to capital gains tax. Profits from spread betting gains are tax free, but the spreads are traditionally wider (although they are getting very competitive these days so this difference is getting virtually being erased).
Traditionally, most institutional money managers have been limited to buying securities only. Spread betters can take advantage of this as fund managers are forced to exit shares if a share price hits key stop-loss levels which means that selling can continue for quite sometime long after the news event which caused the pressure on the share price has passed. Also, money managers tend to drop non-performing companies in search for better returns.
Shorting shares carries more risks than simply buying a share because you think it can go up. There are more dangers and pitfalls - but it can also be a highly lucrative activity. With equity markets hitting four-year highs and concerns about the economy going forward, there may be more and more profit-making opportunities ahead for brave short investors. If you are not already there, now looks like a good time to start getting clued up on this exciting investment arena. But be careful. More information about shorting and spread betting is available in this section
Did you know? The term 'bear' apparently has its origin from bearskin traders in London who developed the technique of selling short skins before the bears had been shot and hence its connection with shorting the market in the expectation of prices falling.
Looking at the last few weeks we saw the Dow Jones drop substantially for this period. The kind of investor that was most prone to panic, was the leveraged spread trader and not without cause. Where we saw the most impact was in hedge funds and CFDs (contracts for difference) market - the areas where there is a lot of leverage. What we saw was an unwinding of a lot of that leverage, and globally I think that process has a lot further to run.
For the individual that has excess cash, that was speculating using a spread betting product, he needs to be very careful, depending on how geared he is, because one gets different levels of gearing, different levels of leverage. Much the same with a person paying off his mortgage. You don't have to borrow 100% of your house - you can only borrow 50% or you could borrow 75%. Here you can also gear to different levels. Now the person that was highly geared on a long position on the Dow, if he didn't have an appropriate stop in place he's taking a bit of pain today.
Now this is exactly what was happening in China. China has looked back at the Japanese example. What happened in Japan in the eighties was that you had this massive rise and this massive run in property values. What people then did - corporations and individuals - they then used that increase in equity, they then withdrew that cash, used that cash to enter into geared instruments on equities, which then resulted in this massive exposure. What then happened is of course the property market unwound, the stock market collapsed, and you have the legacy nearly 20 years later that the Japanese economy is still trying to work out those bad debts, bad loans. I think they classified in the polite term as 'non-performing loans'
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