Going short - how to take advantage of falling markets
Summary: Most investors buy shares with the expectation that they will increase in value: the simple 'buy and hold strategy'. If you look at long-term charts of the stock market, this is the right strategy. After all, in the long run, the stock market rises - in financial lingo, that’s called going long. Contrary to this, you can also go short.
What is going short?
To put it briefly, going short is the following: you sell something you don't own in the hope of buying it back for less at a later time. If this succeeds, you make a profit.
This concept can be difficult to understand. How can you sell something you don't own? In everyday life, there are few examples of going short. But in the stock market, this is a way to benefit from falling prices.
Short and long comparedGoing short and long can be compared to a thermometer. If you expect an increase in prices in the market and you hold a long position, then your position is positive – in other words, above zero. If you don't have any position (so, only cash), then it's zero degrees. If you have a short position, then your position is actually negative. In other words, below zero.
How to short the market ?
Shorting is a complex financial manoeuvre, which requires that you know what you are getting into. Over time, however, it's become an increasingly popular and simpler thing to do. Shorting can most easily be done with derivatives. These are products that are derived from an underlying asset and the price movement in the underlying asset determines the price of the derivative. Products that are available to short the market include: turbos, futures, inverse ETFs, CFDs and options. Availability of these products might differ from region to region.
Please note that derivatives are complex products which are only suitable for advanced investors. It is essential that you understand how they work (and the associated risks) before investing in them.
1. Shorting with futures
As mentioned, there are several ways to go short. A method often used is by shorting futures on an important index like the S&P 500. A future is an agreement where you agree on the price for a possible future delivery (or financial settlement) on the day of expiry. By buying a future, you create a long position. By selling the future you create a short position. Futures can be traded on a daily basis and do not need to be kept in your portfolio until maturity.
Let’s look at an S&P 500 mini future as an example. This future has a contract size of 50 times the index itself. It’s called a mini future because the standard future contract for the S&P 500 has a contract size of 250 times the index.
Let’s say that this index trades around 4,100 points and your view is that the market will fall to approximately 3,800 points. To profit from that, you will sell 5 S&P 500 mini futures at 4,100. If your view is right and the market trades at 3,800 points, you will have earned 300 points in the index. Measured in dollars, you have a profit. But how much? Your profit would be 300 points * 50 (contract size) * 5 (number of contracts) = $75,000. But be aware, by taking this position you would have created a short exposure of 50 * 4,100 * 5 = $1,025,000. Every percent the market rises will lead to a loss of $10,250!
To calculate your exposure, multiply the contract size with the current level of the index and you will know your exposure per future.
Also be aware that entering a short position will lead to margin (a form of collateral). This is because there is no initial exchange of money if you sell (or buy) a future. There is just the agreement, and the financial settlement will be in the future. This means that you need to have enough capital in your trading account to be able to sell the future (enter the agreement) in the first place.
2. Inverse ETFs
Another way of shorting the market is via an inverse ETF. A normal ETF tracks an underlying asset, most of the time an index. If the asset rises, the ETF will rise and vice versa. The inverse ETF works the opposite way. It will move – on a daily basis – in the opposite direction of the underlying index. So, if the underlying index declines, the inverse ETF will gain in price (and vice versa). This is also a method of shorting the market. If you buy an inverse ETF, you short the market.
Closely related to this is the leveraged inverse ETF. There is a leveraged component added to the inverse ETF, so the percent change in the underlying index will be multiplied by the leverage factor. Normally, that leverage factor is two or three times the daily percent change of the underlying index.
3. Buying put options
The third way to short the market is by using options. The buyer of a put option has the right to sell the underlying asset for a predetermined price (the strike price) for a predetermined period of time (until expiration). Buying a put option can be regarded as an insurance for an existing long position.
But if the investor does not hold the underlying, a long put can be regarded as a way to short the market because a long put will increase in price if the market falls.
There are put options available on individual stocks but also on most indices. This gives the investor the ability to create a short position in the market where the premium paid for the put option is the maximum loss.
Let’s look at an example. Say the S&P 500 is trading at 4,100 and there’s a put option for almost three months ahead at USD 4,000, which trades around $131. Because the contract size of this option is 100, your initial investment would be $13,100. Let’s then say that the S&P 500 index falls to 3,800 in that month, then the value of that put would be $200 (strike price of 4,000 minus actual level of the index at that moment, which we established was 3,800). In other words, you are entitled to sell for 4,000, while the actual price is 3,800. This sets the value of that right to be at least 200. If we multiply this by the contract size of 100, the value per put option will be $20,000.
If you are a long-term buy-and-hold investor, going short is probably not part of your investment strategy. You may know that the opportunity exists, but you don’t put that knowledge into practice. If you are a more active trader, this may be different. Going short can add value to your strategy. After all, going short will benefit from a falling market. But be aware of the risks involved in a short market position, especially with leveraged products. In case the market does rise (and you lose money), it is important to maintain a strict risk management approach.
In short, going short is an extra way to respond to 'anticipated movements in the stock market'. And for the active trader, it does not matter whether that movement is up or down. Something to think about, especially in fragile and uncertain market conditions.
Investing carries risk. Your investment may decrease in value.
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