A falling stock price is the bugbear of an investor, but to a trader, it’s an opportunity to make money – by being on the ‘short’ side.
You could do this by ‘short-selling’ the stock, which is the reverse of normal sharemarket practice: you sell the stock first, and buy it later. You borrow the stock from your broker (who borrows it from institutional shareholders) to sell it, and if the price falls you profit, because your selling price is more than your buying price.
Traders wishing to go short on a stock can also use stock futures or options. For example, if you think the price of a share is about to fall, you could buy a put option, seeking to sell your shares now for a higher price than you believe you could get by exercise time.
You could also write a call option, so that the buyer of the option agrees to buy the shares from you now, for more than you believe they will be worth at expiry.
The simplest method of going short is using contracts for difference (CFDs). A CFD is a financial derivative that represents a theoretical order to buy or sell a certain number of shares: the investor simply closes the transaction by taking the opposite action.
A ‘short’ CFD gives the benefit of a fall in the share price. The investor’s final profit or loss is determined by the difference between the opening and closing price, with the difference paid at the close of the contract.
Using CFDs is a much simpler method of shorting than any of the others available. You don’t have to borrow the stock; you are not limited by contract size; there is no set expiry, meaning the position can stay open as long as you like; and the holder of a short CFD is paid interest (the bank bill rate minus a margin) while the position is open – whereas the holder of a short option position effectively pays time decay for that position.
But whichever method you use, you must first identify a stock to short.
Karl Siegling, managing director of absolute-return fund Cadence Capital, says the decision is mostly fundamentally driven: he uses technical analysis to confirm when the price has turned.
“Firstly, you’ve got to identify an over-valued situation. Fundamentally you have worked out a valuation that you believe is lower than the share price. That’s a good starting point for shorting a stock – but you can’t just short it because you believe it is over-valued, because it might go a lot higher. You can’t short it until it starts turning around and falling.”
That’s where Siegling uses the charts. “The stock has to have turned from a price point of view, before you start shorting it. I like to establish that price point using price and volume – but nothing really complicated, just a break in the trend. I just use a candlestick chart, I don’t even need a moving average crossover. I just need to see how the stock is trading over time: in the end, I’m a trend follower. Trends are quite easy to identify once they’re in place,” says Siegling.
Andrew Doig, senior analyst at charting and technical analysis education firm SpiWatch, says there are many technical indicators that chartists use to identify a potential short. “I have a series of indicators that most people who use technical analysis would have in their programs – I would be looking at my top six short-term indicators to be extremely overbought, on a daily timeframe basis. All of that has to be backed up by fundamental analysis.”
Doig uses a relative strength index (RSI), a stochastic oscillator, a momentum oscillator, a standard stgiation, Bollinger Bands and “a couple of my own indicators that you can’t get on the programs.”
“I look at the relationship between the open, the high and the close for a day or a period. Obviously, if you’re looking to go short, you’re looking for a top pattern on the chart. For a short, I pay careful attention to the volume – I would be looking for a major blow-out on the volume side to suggest that a top has been posted.”
To enter a short position, Doig is looking for his “top six short-term indicators to be extremely overbought,” on a daily timeframe basis. “If I was looking for extreme confirmation for a longer-term short – to be held three to five weeks – I would be looking for the same sort of signals from my weekly timeframe indicators.”
He also uses a moving average – usually a 50-day or 200-day moving average – looking for when the cash price is too far away from the moving average. “You usually find that the cash price stays within a maximum range away from the moving average.
“When the cash price gets way above the moving average – much further than you would normally expect to see it, even in a bullish market – it’s pretty clear that we’ve got on a problem on the long side. If I’ve already established that my indicators are extremely overbought, a short is certainly applicable,” says Doig.
To short profitably, Doig says stops must be used: a ‘limit price’ lower down that acts as a stop-profit in the shorting sense – and a stop on the upside “to protect me if I totally stuff up.”
“You make much more money on short positions much more quickly than you do on long positions. But you’ve got to be disciplined. I wouldn’t bother shorting unless I thought I could get a return of 25-30 per cent. There’s no reason why if you use the correct derivatives, you can’t get that each and every time. I think CFDs are going to work better for most people – they are far simpler than other methods.”
Siegling prefers actual short-selling, by borrowing the stock from a prime broker: he doesn’t use options and futures because “they make it too complicated.” He says shorting in this way is simply “the mirror image” of going long. “If you buy by picking up parcels, you should short exactly the same way – by de-accumulating. It’s the mirror image of picking up parcels in a rising trend.”
But he agrees that CFDs suit retail investors: “Synthetically replicating the stock using a CFD is the closest retail investors can get to short-selling.”
Jonathan Barratt, managing director of Commodity Broking Services, points clients wanting to go short straight to CFDs, because of the simplicity. In fact, he says CFDs should only ever be used for shorting – unless the client fully understands the use of leverage inherent in a long CFD.
“The ability to go long the equity and short the CFD, in particular, is a great tool. You’re not realising capital gains tax by selling the shares, but you’re taking advantage of the market moving against the stock.
“Say ANZ is a large holding of your super – but you’re currently losing a lot of money on it. You don’t want to get out of ANZ because you want the dividend, and you don’t want to realise the gain. You can simply reduce your exposure by being short the CFD. If ANZ goes up, you’re going to lose money on the CFD, and you’ll have to buy the CFDs back – but you’re staying long in the equity,” says Barratt.