Four short-selling strategies in a volatile market

Just last week we witnessed the dream run for short-selling investors as the S&P/ASX 200 slid nearly 10% to technical support levels before rallying on Friday.

But even for those who missed the opportunity, short-selling can still offer unique advantages in the current investment climate, with companies issuing profit warnings left and right and the Australian market seesawing over the conflicting overseas economic data.

Eureka Report has kept you abreast about what sectors professionals are shorting the most at the moment and has revealed some of the strategies available to short-selling, such as how to profit from profit warnings by shorting stocks that have released bad news.

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There are three broad reasons investors might choose to short-sell:

• They believe the market will fall;
• They want to smooth their returns over time, eliminating downside risk;
• They have identified a specific situation to short-sell, for example if they believe the Commonwealth Bank is looking too expensive.

Simply put, short-selling is the practice of borrowing a security and selling it immediately, with the obligation to buy it back later in the hope that its value will have fallen.

The most straightforward way to short-sell a stock or index is to open an account with a full-service broker, but this typically requires a significant amount of capital. According to investment bank UBS, typically it is its ultra-high net worth clients who engage in short-selling, and they have a minimum balance of $1 million. UBS does not have an off-the-shelf product and usually has several discussions with its clients to ensure they understand the risks.

Direct equity short-selling

For those investors who want to steer clear of derivatives and their leveraged offerings, a limited number of brokers provide the option to directly short-sell stocks online or over the phone. But be warned: short-selling is a complex area and investors can potentially lose more than they put in.

One such broker is the Macquarie Prime Facility, which charges a minimum trading fee of $19.95 online or 0.12% of the total value of the trade once the amount exceeds around $17,000. This is paid at the start when investors borrow the shares to sell them immediately and when they place the order to buy them back within the time limit of one year.

To protect the investment bank from potential losses, investors have to outlay capital into a margin account. The amount depends on the each stock’s margin rates and its market movements: if the share price lifts investors will need to deposit more funds into the account to ensure the margin is maintained, but if it falls some of their funds will be freed up.

Additionally, investors have to pay a variable stock-lending fee, which in Macquarie’s case is currently 2.95% per annum. However, this is mostly offset by the 2.75% interest per annum that investors earn on their shorting position.

The benefit of short-selling equity is that investors are trading directly on the stock exchange, thereby reducing liquidity risk. However, some stocks can still be difficult to short-sell because there might not be enough available supply, as the diagram below illustrates.

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What turns a lot of investors away from short-selling stocks is the fact they can’t leverage their investments – they have to outlay more capital for a smaller percentage return. And this is where derivatives come into play.

Shorting through derivatives

The derivatives that can be used to short a stock or stockmarket are warrants, exchange-traded options and contracts for difference (CFDs), and each have their own perks and risks.

Contracts For Difference

One of the most common methods of shorting the market are CFDs because of their simplicity compared to other derivatives and because they are highly leveraged instruments, exposing investors to full share price movements while only requiring a small percentage of capital.

For example, an investor might need a margin of $5,000 to buy $50,000 worth of shares. If the shares drop by 10% they will double their money. But, on the other hand, if the market moves against them, the loss will eat into their initial margin. This could require the investor to top up the margin, and this is why they are at risk of losing more than their initial capital.

Technical analyst David Hunt, from Profit Hunters Group, believes CFDs are most suited to high conviction trades because while they are the easiest derivative to short-sell, they are also the riskiest.

“CFDs are much more flexible and directional when you know a stock is going to collapse, like National Australia Bank was,” Hunt said. “That’s the weakest bank we have and it rallied a lot further than it should have gone [at $33] – that’s a good short.”

CommSec and IG markets are just two brokers among many that provide several different types of CFDs. CommSec charges the greater of $14.95 or 0.12% of the total trade, which is paid when opening and closing positions and is reasonably competitive with other brokers.

Exchange-Traded Options

Another strategy is to buy an exchange-traded put option. This is less risky because the loss is limited to the premium paid for the option, while investors can still potentially make a leveraged gain.

Buying a put option provides an investor with the right, but not the obligation, to sell a specific number of securities at a set price within a stipulated time period. If the stock falls below the set price, the investor can book the difference minus the cost of buying the put option.

Brokers charge a higher fee for options than for CFDs, with the commission the greater of around $35 or 0.35% of the trading value.

Warrants

Put warrants are another derivative that investors can use to short stocks with. Like with put options, they give leveraged exposure to the underlying instrument and investors can make a profit if the share price falls below the exercise price.

The key differences between them are that put warrants can be traded just like shares, their brokerage fees are the same as equities, and they are issued by financial institutions, which are obliged to create a market for the investor.

For Hunt, the key disadvantages for warrants and options are the element of timing and that price makers have more control over the area.

“It’s hard enough working out whether the stock is going up or down, let alone how long it will take to get there and whether the volatility will increase by the amount you expect,” he said.

Hunt advises investors to find a product with a strong correlation between its price and the underlying security, as some of them are traded on an ‘artificial market’ where the entity that creates the market is free to set prices as it chooses. Macquarie Prime Facility is one example as it reserves the right to change the prices of its products under certain conditions.

“Be aware that the price-makers, the CFD brokers and the investment banks have to get paid, and generally the more complicated the structure the more fees there are,” he said.

As with any investment, make sure you do your research and shop around. Read into brokers’ product disclosure statements to see the specifics of what they offer and the costs.