If there is one thing that can really rankle investors, it is short selling. To them, it goes against the grain — it is the antithesis of what the share market is all about.
For them, the share market is about investing for long-term gains. Picking companies with good prospects, and holding on to them through thick and thin.
Perhaps the real bugbear comes from the way short selling works. Without financial institutions lending shares in the first place, short selling just wouldn’t be possible.
The reason stems from the way shares are settled. Because settlement takes place two days after a trade, the short seller must be able to hand over shares to fulfil their settlement commitments.
Unless they can borrow these shares from a third party, anyone short selling would have nothing to hand over.
In lending these shares, you could argue these institutions are conflicted. They select and hold shares on behalf of their investors. Yet, in lending the very same shares to short sellers, it could put these same clients at a disadvantage.
In other words, if the share price tanks, it is their own clients who lose real money.
That is why some institutions, including brokers, no longer offer short selling. For the fees generated from lending shares, they don’t believe it is worth the heartache…or negative publicity.
The issue, though, is that without being able to trade both directions of the market, investors and traders are missing a big part of the action. Especially if the market rolls over, and starts heading down.
So what can an investor do?
Well, one thing is to buy put options. In doing so, it gives the buyer the right to offload the underlying shares, at the option’ strike price, at any time until the option expires.
While that all sounds well and good, the key word here is ‘expiry’. Because all options have a finite life, the anticipated move needs to happen before the option expires. Otherwise, the option will expire worthless.
Another limitation is the number of shares on which you can trade options. On the ASX, that number is around 60–70. Certainly handy if the share options you want to trade are among that group. But not so much, however, if there are no options listed for your shares.
One way you can short the market, though — without short selling shares — is using inverse ETFs. An inverse ETF, as the name implies, works inversely (or opposite) to the market.
When the market takes a fall, the value of an inverse ETF rallies. And, when the market rallies, the value of an inverse ETF decreases.
So how does an inverse index ETF work?
An inverse ETF short sells index futures. Unlike the share market, short selling an index is not a big deal. The reason for that is the way an index settles.
At the end of the day’s trading session, the index is marked to market. What that means, is that the closing price becomes the day’s settlement price. Importantly, though, it is cash-settled.
That means that rather than shares (in the index) changing hands, funds flow from one account to another.
If, for example, you buy an index and it rallies, money comes into your account — marked against the closing price. And, if the index falls, money comes out of your account — again marked against the close.
Buying an inverse ETF can be a great way to trade the market if you think it is heading down. It also helps you to trade both directions if you team it up with a long-only ETF.
That is, you buy the long-only ETF — say, an ASX 200 Index ETF — when you believe the market is going to rally. You then rotate out of that (close out your long position) and into an inverse ETF, if you believe the market is going to fall.
For one, it enables you to trade the market without having to pick individual shares. And second, you don’t need to set up an account to short sell — the inverse ETF does that for you.
Editor, Options Trader