Today I want to look at the ‘other’ side of an investment.
The side that retail investors hate, but professional investors love.
To some it’s un-Australian. You’ll be betting on failure. But if your goal is to make money in the share market, then learning this could double your chances to profit. It allows you to invest in all types of market — booms and busts.
And it’s actually a crucial tool to weed out fraud, failures and dishonest directors. The true enemies of ordinary shareholders.
With this strategy up your sleeve you could have made 26% on Domino’s Pizza [ASX:DMP], 12% on Telstra [ASX:TLS] or 10.5% on Commonwealth Bank of Australia [ASX:CBA] in just the month of August.
Compare that to only a 0.8% fall in the ASX200 index.
I’m talking of course about short selling.
So what is short selling, and how can you do it?
First things first, what short selling is.
Short selling is a process as old as the markets themselves. It’s a bet on the decline of a share price. The mechanics may seem a bit strange; it involves borrowing a share to sell it, before buying it back later at — hopefully — a lower price. The difference is your profit minus any expenses.
So you’re hoping the price falls. The opposite of what you want when you buy a stock. In fact, buying a stock is often called ‘going long’, compared to ‘going short’ or ‘shorting’.
It seems complicated, but in practice your broker or platform will work out the mechanics behind the scenes.
Here are two options on how to short sell.
The first option is to see if your broker offers the option. Most do, especially on the top 100 stocks. Shorting smaller stocks is harder, as there is less stock available to borrow, so it may not be available for smaller stocks.
As you’re borrowing a stock, there’s an interest charge to pay for each day you have it shorted. This is something to consider as a cost of shorting.
But a short trade is usually looking for a sharp, steep fall, so you probably won’t be holding on too long. I’ll explain more about this shortly.
The second way to short is to use a Contracts For Difference (CFD) provider. Be careful here as they also offer leverage, which involves betting with more than the money you have invested. Though you do not need to use this leverage, it can be tempting. Avoid this temptation.
A warning and three big tips to double your chances
Now, a word of caution.
As with anything new, you should treat this process very carefully. Most CFD providers allow you to paper trade on their platforms first, and I strongly suggest you do this first to practice short selling.
And if you do ever start with real money, start very, very small. And only ever use money you can afford to lose. And practice for at least 12 months (I guarantee you will make a lot of mistakes, which will essentially be the cost of your education).
And also remember that, in theory at least, short selling makes your potential losses unlimited. After all, there’s no limit to the level a share price can rise. Whereas when you buy a stock, the worst case is if the share price goes to $0. So your losses are limited to the amount you invest.
With that out the way, let’s say you want to start shorting stocks. How should you go about it?
Well, here’s my three top tips for developing a shorting strategy.
- Only short sell in bear markets. Although professionals short sell in all types of market, new short investors should look for markets that are in downtrends. A break of an uptrend trend can also be a good opportunity. But only experienced pros should short strong up trends unless you want to take on the might of the masses. You need to know what stage of the economic cycle we are in.
- Short companies with huge expectations. A lot of the best shorting opportunities come from stocks where the investing public has factored in a lot of hype to the share price. A slight fail in meeting these ambitious goals can result in huge falls. NetFlix [NASDAQ:NFLX] and Amazon [NASDAQ:AMZN] are two big ones that come to mind.
- Don’t be greedy. When you put it all together, it becomes clear that selling short is a high-risk proposition that can only work at certain times. And even then, it’s unlikely to work for long. So when you find yourself with a profit from selling short, take some off the table. Let some ride, if you like, but remember that, eventually, the market’s long-term upward trend will return, and it will be hard to swim against that tide.
More knowledge is always better when it comes to short selling
Once you learn how to use shorting, it can open up a lot of possibilities you couldn’t imagine before. It’s like going to the casino and suddenly being able to bet on the roulette table on both red AND black. Or moving from draughts to chess.
But, like in the casino, this extra choice doesn’t mean you will win. It might just be a new way to lose!
I’ll stress this again, be very careful.
But the more you learn, the better your chances will be in the markets. At the very least you will be able to avoid buying into certain stocks you know short sellers are attacking. More knowledge is never a bad thing.
Editor, Money Morning
PS: Markets move in cycles. There are times they are likely to move higher, and times they are likely to move lower. Both buyers and short sellers can benefit from knowing what stage of the cycle we are in. Through studying centuries of stock and housing market trends, my colleague Phil Anderson has acquired remarkable insight into the timing of these cycles. This knowledge could change your whole approach to investing. Read more here.