We will use a hypothetical example to illustrate. Ronnie undertook research on the Australian market and following his research he took a negative view of XYZ Department Stores Ltd. He believed the future for XYZ was quite bleak because their buildings were run down, staff were currently striking due to a pay dispute, and to top it off their revenue was forecast to fall substantially. After a quick analysis of the company’s financials and other fundamental tools available on his online platform, he concludes that the price of XYZ is set to fall.
In order for Ronnie to short sell XYZ to benefit from any potential fall in the share price, he must borrow the shares. This begs the questions: how do I sell something I don’t own? Direct Market Access CFD providers organise this service for traders everyday and borrow the underlying shares for clients so they can short sell the CFD.
Ronnie short sells 1,000 XYZ shares at $1 to open a $1,000 position.
Reporting day came and as Ronnie had predicted, the results were well below expectations; however, the company also announced a rights issue of 1 share for every 10 shares held. The new shares could be purchased by existing shareholders at 50 cents , a discount to the prevailing market price. Consequentially the shares opened substantially lower after the announcement.
Ronnie was a happy man; he bought back the shares on the open at 75 cents per share outlaying a total of $750 but he was also obliged to buy 100 shares, if the owner of the shares chose to participate in the rights issue.
Ronnie sold 1,000 shares of XYZ at $1.00 a share receiving a total of $1,000
Ronnie purchased 1,000 shares back at 75 cents a share, outlaying a total of $750
$1,000 – $750 = $250 profit.
The owner of the shares did wish to participate in the rights issue so Ronnie had an obligation to participate in the rights issue. He was required to pay the difference between the price the owner of the shares had to cover the difference in the market price and the rights issue price. He bought 100 shares at the market price of 80 cents but the owner was required to cover 50 cents for each of the shares as per the rights issue.
Market price was 80 cents and rights issue price 50 cents. Difference is 30 cents.
Ronnie was required to pay 30 cents x 100 shares = $30
Therefore, Ronnie made a profit of $250 from the initial short sale; however, he lost $30 from the rights issue. The result is a profit of $220.
CFDs provide a mechanism to short sell; and a holder of any short position during an entitlement period will be required to pass on any rights. It is important to understand that the principals are exactly the same should Ronnie had used share or CFDs during a capital raising.
By Matt Press, Head of Sales, FP Markets
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