Updated: May 17
Investors have been kept informed by the popular media over the last twelve months about the evil deeds perpetrated by the financial institutions selling-short our investments, and how the regulators came to our rescue to save us from this insidious behavior. Unfortunately, short-selling became one of the main culprits in the recent market turmoil because it is so easy to blame a technique that most retail investors do not fully understand. The short-selling of shares or futures is not the domain of institutions, and is an investment technique that can and should be used by small retail brokerage clients.
Short-selling is the ability to sell a share or commodity that you do not own, so that you can potentially buy back later at a lower price to profit from a fall in the market. Short-selling is what you would do, if you believe a particular share or commodity was about to fall in value. The opposite of short-selling is "going long". A long market position is simply a "buy" to open and "sell" to close set of transactions, the same as any normal share market trade.
If a share trader wishes to profit from the decreasing price of a particular share, then they can borrow the share and sell it to open a market position. This process of borrowing shares and selling-short to open a position relies on the fact that securities returned are fungible, which means the securities are capable of mutual substitution. The securities returned do not need to be the same original securities borrowed. The borrowing process is arranged and handled by your broker, and the understanding of the back-office mechanics for this process does not have to be understood by the retail investor to be successful at short-selling shares, unless you wish to become a licensed dealer.
For example, say that shares in XYZ Ltd are currently selling for $1 per share. A short-seller would borrow 10,000 shares of XYZ Ltd, and then immediately sell those shares for a total of $10,000. If the price of XYZ Ltd later falls to 50 cents per share, the short-seller would then buy back 10,000 shares for $5,000, return the shares to their original owner and make a $5,000 profit before fees.
Short-selling transactions are similar when dealing with futures contracts over commodities and other financial instruments. Short positions in futures contracts are not borrowed because futures are standardised exchangeable contracts over an underlying physical commodity or financial instrument, and speculators never usually hold any position after first notice day when dealing on the futures exchanges.
The ban on short-selling caused many problems, which we experienced first-hand when the share market liquidity started to decrease and the bid / offer spreads started to widen. The regulators were worried that some of our biggest companies could be crippled, during the recent market volatility, by international hedge funds wanting to make quick dollars by short-selling blue-chip companies. Reports from vocal market participants and my own analysis support the conclusion that without short-selling, listed securities will be incorrectly priced by the financial markets and result in increased costs. There is statistically significant evidence showing that trading volumes declined following the short-selling ban and that spreads increased resulting in higher prices paid by retail clients. The move to ban short-selling was a politically motivated move, by the regulators and politicians, to create a new scapegoat for the recent market correction.
The main reason to become involved in short-selling is because it gives you more opportunities as a trader or investor. If you start utilising this simple technique, then not only can you trade in the expectation to make a profit when the market is rising, but you can now look for opportunities when the market is falling. You can make a good income from correctly picking bad or overvalued companies and then short-selling.
If you are trading physical shares short, then you must be aware that the borrower of the shares is required to pay any declared dividends, so it is best to avoid trading during the dividend period or instead use a derivative contract to trade short. It is important to understand that "going long" has a completely different risk profile to "going short". Losses are limited when trading long as the price of a share can only go to zero. Profits are limited when short-selling because the price of the shares can only theoretically go to zero, but the loss potential has no upper limit, which means that the trader could lose more than the original value of the shares.
If you have ever had any experience trading the share market, then you will know that the above mentioned situation is only a hypothetical scenario. I strongly doubt any professional full-time veteran of the financial services industry has ever seen the above mentioned worst case event in a real life situation. I am saying this because people hear this hypothetical scenario and start to believe it happens on a regular basis, but, it does not. Professional licensed advisors will always give you the worst possible scenario no matter how rare the possibility because it is their responsibility to keep you fully informed. Also, this scenario should never happen due to the use of stop-loss orders, monitoring and financial markets will not move to infinity because it is a market place of individual investors all with different opinions. For example, the only way that you could "lose more than the original value of the shares" is if the price of the blue-chip shares that you were short more than doubled in price over-night. My point is that you should not let concerns over a hypothetical standard risk disclaimer prevent you from learning how "going short" is a useful technique for successfully trading the markets.
If you have ever wished that you could continue to profit while the markets were falling, then now is the time to start learning about short-selling. The markets will always produce rising of falling trends, and with the abundance of trading opportunities available there is no reason for any investor to exclusively trade the upside of the share market when there are potential profits from trading both long and short market directions.
Matthew Corica http://www.titansecurities.com.au is a full-time private trader and managing director of licensed investment firm Titan Securities Pty Ltd AFSL: 307040.
This article has been written for educational purposes only. If the reader wishes to trade any financial market due to this article, then to satisfy any unforeseen disclosure obligations of the writer as an Australian Financial Services Licence holder, please refer to the standard risk disclaimer located at http://www.titansecurities.com.au
29th July 2009
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