Falling share prices are generally bad news for investors, but did you know it is actually possible to profit from a downturn in the market by short-selling shares?
While a traditional investment strategy involves buying shares at a low price and then (hopefully) selling at a higher price, short-selling works in the opposite way.
So basically what you do is ‘borrow’ shares off someone and sell them in the hope of buying them back later on at a cheaper price, leaving you to pocket the difference (minus a small commission).
A practical example
Darren Winters, founder of stock market investment training company WIN Investing, provides a practical example:
“Let's say you borrowed and sold shares in a bank at the beginning of the month at 348p,” explains Winters. “You wait for four weeks then, after the price has dropped to 248p, you buy back the stock at that price.
“You will have made a profit of 100p per share. You then give the shares back to the original owner from who you borrowed them, plus a little bit of interest which is classified as ‘borrowing costs’. The rest of the difference is all profit for you.”
A quick word of warning
Unsurprisingly, short-selling is extremely popular during a bear market – where many shares drop in value – such as we find ourselves at the moment.
And while the strategy has helped many investors to a handsome profit in a short space of time, it’s important to note that shorting is extremely risky. With a traditional share-trading model you can never lose more than the money you originally invested, as a stock’s value can’t fall below zero.
However, because there is no limit to how high a share price can rise, there is theoretically no limit to how much money you can lose when short-selling.
That makes it essential you monitor your investments regularly, or risk ending up significantly out of pocket. It might also be a good idea to avoid thinly-traded shares, which are far riskier. Stick to big companies with freely-traded shares, especially if you are just starting out.
So how do you do it?
The first thing you need to do is contact your stockbroker and ask what stocks are available for borrowing.
“The process might sound complicated, but it's quite automatic once you got authorisation from your broker that you can short sell stocks, and that they have shares in whichever stock you interested in trading,” says Winters at WIN Investing.
So how do you identify a stock that is suitable for shorting? You need to research and follow some shares closely and spot certain trends.
Trends to look out for when shorting:
1. Rapid decelerating sales and earnings/profits growth, both on a year over year and quarter over quarter basis.
2. Companies where the original concept or model for the business or major product is broken, is in decline or going out of date. This might, for instance, be a technology based product where new technology is starting to supersede it.
3. Companies whose products or the services that they deliver are not sufficiently different from their competitors. A good example is the mobile companies where we can see how difficult it is for them to remain consistently successful. They compete on price, their services are generic and can't be differentiated.
4. Big merger and acquisition announcements by companies that are ego-driven at the top end of the market. Watch these acquisitions, for they tend to over extend the companies and management do these deals because of their big egos and not to enhance shareholder value. RBS's ABM Amro acquisition is an example, as well as Vodafone's acquisitions in the late nineties and early 2000's.
The golden rules of shorting
According to Winters, there are a few golden rules to follow. “Shorting stocks in a bear market increases your probability of success so try not to short stocks in a bull (rising) market.”
You also need to manage your risk very closely and aggressively, he adds. “Don't let a short term trade turn into a long term trade by hanging on to it too long while waiting for it to go down. Admit to yourself that you were wrong about that share and close the trade immediately.”
“And remember, stocks go down faster than they go up.”
Certainly not for everyone
There’s no doubt that shorting is a lucrative strategy - especially given the status of the market at present – but it’s also a risky strategy that could see you lose big in a matter of hours.
Don’t even bother with shorting unless you can: (a) keep a constant eye on your investments; and (b) can afford to lose not only the money you invested, but some additional funds as well.
