Long and short of it

Published in the Money Magazine, July 2013 by Peter Freeman

Profiting from shares is not just a matter of trying to buy low and sell high. 

It is also possible to profit by betting that the share market or the price of a particular share will fall.

At the time of writing, this strategy broadly known as shorting was looking increasingly attractive with a range of experts cautioning that local shares were due for a significant correction, probably in the next six months.

"The odds on a 15% to 20% fall by early next year are high," warns Dale Gillham, executive director of investment education firm Wealth Within. 

"The uncertain global financial and economic situation means anything could happen." 

Share investors who have built up big paper profits from share gains over the past year or so can use a range of alternative strategies. 

As Gillham explains, these include: taking all or part of you unrealised gains now by simply selling shares; betting against the market by using traditional shorting techniques; buying put options or warrants; short selling contracts for difference (CFDs).

In its most basic form, short selling involves selling stocks you don’t own in the hope of being able to buy them more cheaply before the delivery date.

Gillham argues that most investors sitting on big gains shouldn’t short sell, but instead choose to take profits by selling shares, mainly because it is the simplest.

As for those still largely in cash, their best approach, he adds, is to stay on the sidelines, at least for the time being.

"Shorting can deliver significant profits, but it is a strategy that requires expertise and practice, and most investors simply don’t have the skill," he says.

In other words, those new to shorting shouldn’t be looking to try to use it this time hut rather see it as another investment weapon that is worth investigating for future use.

Traditionally an investor who went short on a particular stock followed the ASX rules about shares they could short sell and, due to the fact settlement is required within three days, sold shares they didn’t own and then bought them back very quickly, often on the same day.

A more flexible variation on this approach involves entering into a loan arrangement with a broker and lender where you use borrowed money to pay the cost of borrowing the shares you want to short sell from a large financial institution.

Because you actually have the shares, you aren’t bound by the official ASX shorting rules and so don’t have to settle within the normal three days. 

This gives you more time for your short to pay off.

A simpler option is to short sell CFDs. 

"If you know what you are doing, this is probably the best way to short a stock," says Gillham, adding that it can he a particularly useful approach for those who own shares they think might be about to fall.

"By short selling CFDs over the same shares, you can hedge against a price fall rather than simply selling the shares, which might trigger a lot of capital gains tax," he says.

As usual, anyone considering trading CFDs needs to understand that they are highly leveraged contracts that can result in heavy losses if prices suddenly move against you.

But for those familiar with using CFDs to go long, using these contracts to short sell should be straightforward.

This is because you will have to pay the same sort of margin (often around 5-10% of the underlying value of the contract) and commission to the CFD provider (such as IG and CMC) as when you go long.

One benefit of shorting is the fact that you actually earn interest when you short sell CFDs, rather than pay interest.

Remember, when shorting you will manage your risk by setting a "stop buy" order at which you need to close out the contract if the market moves against you rather than a "stop sell".

Back to Articles