Welcome to part five of our free “How to Buy and Sell Shares
[Ed Note: You can now download the entire ‘How to Buy and Sell Shares’ six-part series for FREE. To download your copy right now go here.]
And in this week’s episode I’ll take you through short-selling. Now, before I go on, I should warn you that short-selling isn’t for the novice investor or trader.
Short-selling shares involves more risks than buying shares, so you should only do it with extreme caution. However, that said, there are ways you can reduce your risk so that even a small-time trader or investor can profit from falling markets.
But here I’ll give you a crash course guide to short-selling…
Before I explain how short-selling works, I’ll tell you what it’s used for. Short-selling simply gives you the chance to profit from falling share prices.
Normally, as an investor, you want shares to go up. So you buy at a low price and sell at a high price. The difference between the two is your profit.
Well, with short-selling, it’s exactly the same. Except instead of buying first and selling second, you sell at a high price first and then you buy at a low price second… the difference is your profit.
Now, you’re probably thinking, “How the heck can I sell something I don’t own?!”
It’s a good question. But it’s not as hard as you’d think. And for the most part, you don’t need to worry about what goes on behind the scenes.
All you need to do is either set up a short-selling account with a stockbroking firm, or open an account with a CFD provider.
The downside of using a stockbroking firm is that you’ll probably need a minimum transaction size of $50,000. That clearly knocks most investors out of the game.
The reason for the high minimum transaction size is due to the behind-the-scenes work the broker has to do.
But there is an alternative. If you trade less than $50,000 at a time your best bet is to use CFDs (Contracts for Difference).
I won’t go into the details of CFD trading here, but I’ll make two points: first, CFDs are a leveraged investment product – that means while you can make big profits you can make big losses too. Second, you should read all the information the CFD provider gives you before you enter into a trade.
It’s not super difficult, but if you’re new to the game it can be confusing at first.
If after reading all the info you’re still not sure, don’t worry because I’ll tackle CFDs in Money Weekend at some point over the next few weeks.
Anyway, let’s look at an example of a short-sell. Let’s say a few weeks ago you thought ANZ Bank [ASX: ANZ] shares were over-priced and due to fall… and you wanted to profit from that fall.
Well, what you could have done is short-sell for around $25.50 in mid-February. And now, after the price has fallen 10% you could have bought back yesterday for about $23. Giving you a profit of about $2.50 per share.
You can see this on the chart below:
Source: CMC Markets Stockbroking
And just like when you buy then sell, when you sell then buy, the difference is your profit.
Still, you may ask how this is possible. Right, let me give you the very quick story: when you instruct your broker or CFD provider to short-sell 3,000 – for example – ANZ Bank shares or CFDs, the broker will contact a big investment firm and ask them to lend 3,000 shares of ANZ Bank.
The big investment firm could be a fund manager, pension fund or investment bank.
The investment firm agrees, and receives a fee in return. A bit like how you pay a fee to borrow a DVD from the video store! The investment firm then arranges to transfer the stock to the broker, and the broker sells those borrowed shares on the market.
Then, when it comes to locking in your profit, you instruct the broker or CFD provider to buy back (also known as “cover your position”) 3,000 ANZ Banks shares or CFDs. When the broker has bought the shares back they deliver them back to the investment firm.
And that’s it, your short position is now closed.
However, there is one very important point to mention. And that’s the risk of losses.
When you buy shares of ANZ Bank, the most you can lose is your initial investment amount if the share price falls to zero. So if you buy at yesterday’s price around $23 and the bank goes bust, then you’ll lose $23 per share.
On the other hand, if you short-sell ANZ Bank shares at $23 per share and the shares subsequently rise to $100 per share, then unless you close your position beforehand, you’ll have lost $77 per share!
Do you see what I mean about the risk?
The good thing is, there is a way to limit your risk. Some CFD providers offer guaranteed stop loss orders (GSLOs). Again, I won’t go into detail here, but GSLOs are a good way to minimize your risk should the share price move against you.
Short-selling is a great way to make cash in falling markets. But it can be risky, and you’ve also got to move quickly.
You may have heard the phrase about “Markets taking the stairs on the way up, and the elevator on the way down.” In other words, share prices tend to fall quicker than they rise.
That means you’ve got to be quick – as you’ll have seen from the market action this week. You can see on the chart below it took the market five months to go from 4,650 to nearly 5,000 points…
…It has only taken three weeks for those gains to be wiped out!
If you keep that in mind, and don’t go overboard with the leverage, short-selling can be a useful way of spreading the risk across your portfolio. In fact many traders will typically have long and short trades open at the same time.
Because even in a rising market, there are always stray stocks that can’t keep up and end up getting pushed lower.
So that’s your crash course on short-selling. I’ll drop by with something else for you next week.
P.S. This is just one, of a six-part series written by Money Morning Publisher Kris Sayce. For your convenience we’ve bundled the whole series into a brand new report titled ‘A Beginner’s Guide to the Stock Market: How to Buy and Sell Shares’. In it you’ll find easy–to–read and jargon free instructions on the steps you need to take to jump into the market TODAY and buy and sell your first lot of shares.
If you’ve got an interest in the share market, but completely new to the whole deal and don’t know where to start… download Kris’ new report today and he’ll show you everything you need to know to get started. Go here to download your free report today.