Shorting and Making Money Spread Betting

Q: What is Shorting?

A: Financial spread betting allows you to take advantage of falling prices as well as rising prices. Traditionally, share traders would ‘go to cash’ and stay out of the stock market when it was down-trending. They had no other choice. In a market downturn, they would more likely have ended losing money if they had stayed invested. But spread betting changes all this as it allows you to take a ‘short’ position, meaning you would make money if the price goes down.

Shorting a stock, or a market is the practice of betting an asset will fall in price. Effectively, you borrow a share, sell it, buy it back later at a cheaper price and return it to the lender.

In a nutshell, short selling is thus a way of profiting from a fall in a company’s share price. Buy low, sell high is clearly a great way of making money. Short selling is the opposite of this. When using this speculative tactic, a ‘shorter’ borrows an asset like shares, currencies or oil contracts from another investor and then sells that asset in the relevant market, hoping that the price will fall. The hope is to be able to buy back the asset at an even lower price and then return it to its owner, pocketing the difference on the way. However it is only possible for a trader or investor to short sell a share if there is another investor willing to bet that the shares will not fall as far as the short seller believes.

How does Shorting Works?

Sounds complicated? Well, it really isn’t that complicated… Take actual bricks and mortar as an example. Suppose you sold a property for £400,000 and bought it back a couple of years later for just £300,000, you would have made £100,000. Some investors consider short selling as an unethical practice and argue that it brings abnormal volatility to the market, however the truth is that short selling is required as it can highlight the fact that a company may not be as valuable as people think it is.

In the UK most shorting is done through either contracts for differences or financial spread betting; two products which are in effect very similar – basically they are bets between you and the provider and you are simply speculating on the movement of the security, no shares are being bought or sold directly. Additionally, you don’t borrow anything yourself, you don’t have any legal connection to the company whose share you are trading. Consequently, should you go long with a spread bet on a security this doesn’t give you any shareholder rights to attend company meetings/vote..etc and moreover the spread betting provider is not obliged to actually place the trade in the market (although they do hedge their positions).

Shorting can be applied to securities, commodities and currencies too, and is nothing new. Speculator George Soros famously made a billion pounds shorting the pound in 1992 and contributing to its infamous exit from the Exchange Rate Mechanism.

Don't try and struggle with the idea of selling something you don't own. Just look at it more simply, like 'I think it is weak, the management suck, there is loads of debt, and their business is drying up, I think I'll sell it'

Q: But isn’t shorting too risky?

A: When you short-sell a stock you lose money if the stock moves higher. Arguably it is logical to think that shorting a stock is more risky than going long as the upside of a stock is theoretically unlimited but the downside is limited to 0. This would of course potentially subject you to unlimited losses but the truth is that as the position moves against you the spread betting firm will at some point issue a margin call and ask you to either deposit more monies to keep the position open or close the position. In this way the margin call would act as an almost automated stop loss on imprudent short sales as the spread betting firm will close your short if you do not provide the extra margin required to keep the bet running.

It’s true that with shorting you can never make more than 100% but then this statement implies that people regularly make more than 100% on most of the stocks they buy! If you buy/short shares looking for, expecting AND getting these kinds of profits then you’re world class in my book. Also, all spread betting firms allow you to place stop loss orders on your positions so this would serve as a cap on potential losses.

Do bear in mind that if you are short on a share when it pays a dividend, your position will be debited the value of the dividend, not credited as it would be if you were long the share. For this reason it pays to keep abreast of key calendar and ex-dividend dates

Q: How can I profit from Short Selling?

A: Although most often used by hedge funds short selling as a speculatory tool can be used by anyone who believes a share price is likely to go down in value. For a personal investor there are a number of ways to short-sell a share price of a company or a commodity – the most common of which are spread betting or contracts for difference which allow you to make money on price movements without actually buying the assets in consideration. So basically spread betting or cfds are an agreement between you and the provider to pay out the difference between the starting and closing share prices.

Not many retail investors like to short-sell because it is so unnatural to bet that the share price of a company will go down and also because it is a undeniable that going short is more risky than going long (since there’s no limit on to how much a share price can go up but the downside is always limited to zero). However, it is a fact that shorting provides a great way to profit from share retrenchments and the use of stop losses (especially guaranteed stop losses) can help to reduce the risk of spread betters getting caught on the wrong side of the market. If short selling, it helps to know your profit target in advance – for instance if you want to make 300 index points, then you know that two entry attempts with a 50-point stop loss will only eliminate a third of your potential profit assuming a bet of £1 per point.

Spread betting brokers typically charge financing based on Libor +/- 3%. In theory on short positions you stand to receive a small daily payment. However as the ‘haircut’ is 3%, you will only receive anything if the underlying ‘libor’ exceeds 3%. So for example if relevant labor was 4% and you had a position worth £100,000, you would receive: £100,000 x 1% (4% – 3% = 1%) = £1000 / 365 (days) = 270p a night.