- There are scenarios where you can benefit from the ability to go short
- A CFD account can be a valuable tool for even conservative investors
- Going short brings additional risks and costs that you should understand
Short selling is the black sheep of the investing world. Frowned on by retail investors, regulators and some institutions, many investors simply don’t want to know about it.
In the case of betting against a company’s share price, that’s fair enough. Short selling can be complicated, carry additional risk and many people simply aren’t attracted to the idea of profiting from disaster. There’s something more emotionally satisfying about a ride on the bull market express.
But there are times when short selling, or ‘shorting’, is useful for all investors.
What is ‘shorting’?
In the investing world, there are two positions you can take with respect to an asset (be it a share, bond, currency, commodity or anything else). The first is to buy or hold the asset—in this case you are said to be ‘long’ (or to ‘go long’ when buying). You are long all the investments in your portfolio and long your house (if you own one).
The second approach is to be ‘short’ (or ‘go short’). In the context of shares, this means to sell a share that you don’t currently own—the shares sold are borrowed from a third party. A ‘short’ trade is closed out by buying the shares on-market (at the then prevailing price) and returning them to the party who lent them to you.
You are ‘short’ an asset from an economic perspective any time you position yourself to benefit from a fall in price.
Colloquially, you might also describe yourself as being ‘short’ an asset you would otherwise be expected to own or intend to buy in the future. A person who sells their house in order to rent for a while might be said to be ‘short’ property. Someone who sells all their shares (or simply doesn’t buy any) because they think the market is overheated would be ‘short’ shares. In each case the person will make a gain if house or share prices decline and they are ultimately able to purchase them at a cheaper price.
You have probably taken a short position at some stage or other. Perhaps you’ve delayed a purchase until sale time, or brought forward an overseas trip to take advantage of the strong Aussie dollar. But when might ‘shorting’ be relevant to your investing activities?
Time to short
Unless you are an active trader, it’s unlikely you will be short selling a share, index, bond or commodity because you have a negative view and want to profit from the expected decline in price.
But there are other situations where you might consider going short:
Delayed sales. You may have an investment you wish to sell but the sale can’t be executed quickly. Common examples are; A share with a capital gain you wish to defer; A share with an upcoming dividend payment you are waiting on; Or an illiquid investment in a foreign currency that has profited from foreign exchange movements.
In this case you might want to enter into a separate transaction to short the share or short the AUD against the currency in which your investment is denominated. By entering into a short trade, you can divorce your economic position from the timing of the physical transaction.
Selling restrictions. You might be restricted from selling a particular asset—for instance, employee shares or options—and also from shorting that particular asset. But you may still want to reduce your exposure to the overall market.
For example, if you have employee shares with a substantial capital gain, your profit is exposed to the performance of both the company and the broader market. You could reduce your market exposure by entering into a short position over the ASX 200 index—a commonly traded underlying in both CFD and futures markets (more below).
Structured products. In past Product Sleuth reviews we’ve looked at products that can’t be exited early. If you’re sitting on an unrealised gain on one of these products, a short trade on an equivalent exposure is one way of (to some degree) avoiding the early termination prohibitions or penalties.
For instance, if you have a gain in the Macquarie Step ASX 200 product you could short the ASX 200 index through a CFD or futures trade.
Hedging. It isn’t financially feasible to hedge away all your downside exposure—you have to take risk to get returns. But there might be specific risks you want to reduce.
An obvious example is foreign currency denominated investments. If you’re attracted to Apple or Berkshire Hathaway stock, but not so keen on the USD, shorting the USD (versus the AUD) can enable you to have the best of both worlds. Alternatively, you might have your eye on the shares of a gold producer but be worried about the gold price. Shorting the gold price can enable you to buy the producer but reduce your price risk.
These are some of the situations where even a diehard ‘long only’ investor might consider shorting. But how do you go about it?
As previously mentioned, shares (and some other assets) can actually be sold short. You can borrow shares from a third party and sell them into the market or (when not banned) you can sell shares you don’t own and buy them on-market prior to settlement (‘naked’ short selling).
This won’t work for many assets, nor be suitable for many people. Fortunately, derivatives enable investors to short an asset without needing to go to the hassle, or dealing with the impracticality, of borrowing it first.
There are a few main options:
Contracts for difference (CFDs). Most investors will have used or be aware of CFDs. As the name implies, they are a contract you enter into with the CFD provider to pay or receive the price movement on an underlying asset (together with ‘adjustments’—see below). The essence of a CFD is to replicate the economics of a leveraged investment on the underlying asset. For example, a ‘long’ CFD over BHP with 5% margin (deposit) replicates an investment in a BHP share funded with 95% debt, including debiting your account for interest on the funding and brokerage on the purchase and sale.
There is a lot of hysteria around CFDs—mainly due to the leverage—but there is no need to be spooked. The key is in understanding that a $5 investment (in our example) is actually exposing you to price movements on $100 (in practice the percentage margin changes from asset to asset).
The leverage in CFDs doesn’t come cheap (my provider, IG Markets, charges 2.5% margin) so they aren’t suitable for long term investing. But they can be very handy. You may want to consider establishing a CFD account, just in case.
Consider a situation where you have an investment of 1,000 BHP shares with a large unrealised capital gain. It is April and the financial year has been good to you—a large bonus from your employer and some other gains made during the year. As a result, the top marginal tax rate (46.5%) awaits.
You’ve worked hard and arranged to take 12 months leave without pay starting in July—you’ll be lucky to make it out of the 19% tax bracket next year. If only you could wait to crystallize your BHP capital gain.
CFDs enable you to have your cake and eat it, too. Rather than sitting on your 1,000 BHP shares until July—running the risk the market erodes your profits—a ‘short CFD’ enables you to economically sell 1,000 BHP shares. Any loss on your BHP shares will be matched (pre-tax at least) by a gain on the CFD position.
On the long side, CFDs can also allow you to lock in a purchase price ahead of the physical transaction. A big market fall might see a share hit your ‘buy price’ just after locking up your cash in a term deposit for a month. A CFD (in this case ‘long’) enables you to take advantage of today’s price without needing to bear the hassle and cost of breaking the term deposit.
One of the best things about CFDs is that they can be traded over just about anything and execution is a piece of cake. Shares (Australian and foreign), share indices, foreign currency, gold, silver, oil, agricultural commodities, copper, bonds and many other assets are all able to be traded with a few taps on your computer.
Futures and forwards. Futures are standardised contracts traded on the ASX. Like CFDs, they’re a derivative that allows you to take a long or short position on an underlying asset. By entering into a futures contract you are agreeing to buy or sell an asset at a predetermined price at a future date (the ‘maturity date’).
Futures contracts—traded through brokers like shares—generally have higher minimum trade sizes than CFDs and need to be ‘rolled’ as they reach their maturity date if the position is to be maintained. This makes them more suitable for large investors. ASX listed futures are traded over the major ASX indices (for instance, the ASX 200), agricultural commodities, energy and interest rates.
Forwards (or ‘forward exchange contracts’) are similar to futures but are neither listed nor standardised. They are commonly used in foreign currency markets. By entering an FX forward an investor agrees with a financial institution to exchange Currency A for Currency B at a pre-agreed exchange rate and future date—leaving the investor ‘short’ Currency A and ‘long’ Currency B.
Like futures, forwards are not entered into at the click of a button or even overnight. You will need to put the necessary documentation in place with your financial institution of choice (and they will need credit approval and appropriate security in place). They also need to be ‘rolled’ upon maturity.
Forwards and futures are likely to be cheaper than CFDs, so they are worth considering for larger or long term positions. But for small, short term trades a CFD is likely to be the better option. In many cases they allow you to sit ‘short’ an asset for as long as you please, without having to worry about the contract expiring. Plus it’s hard to beat the simplicity of being able to trade just about anything through a single online account.
Options. Many shares have a string of related ASX listed options—both puts and calls. CBA, for instance, has 556 call options and 548 put options available for purchase through a brokerage account.
Buying put options is another way to be ‘short’ an asset. However, unlike a CFD or futures contract, an option is a one way proposition—the buyer of a put option can sell at the predetermined price but isn’t required to (thus retaining any upside). This makes an option more like an insurance contract (downside protection) than the economic equivalent of an asset sale.
The main problem with options is their cost. For the writer of the option, it’s all downside if the bet goes against them. They price the option premium (the amount you pay to buy the option) accordingly.
- Short selling. As mentioned, shares and other assets (for instance, gold bullion) can be borrowed and sold to create a short position—suitable for large investors and institutions but for small investors not very practical. As a result, not all brokers even offer this service to retail clients.
So, these are your shorting options. But what of the pitfalls?
Pitfalls of being short
Shorting generally has one major risk that doesn’t exist with ‘long only’ investing—unlimited exposure. When you buy a share the most you can lose is the amount you have invested. But when you’re short your potential loss is unlimited.
Practically speaking this is not a major concern. In the situations we suggest you might want to consider shorting, you’re offsetting another economic exposure—not creating a ‘net’ short position—so your short and long positions should balance out.
What are the other issues to be aware of?
Adjustments. The idea of derivatives is to replicate the economics of the underlying asset. It’s usually possible for necessary ‘adjustments’ to be made to the contract to give effect to this. For instance, if a company announces a share split any option contract over the shares will be adjusted to reflect the increased number of shares on issue (this ensures the spirit of the deal agreed between the parties is preserved).
In the case of CFDs, in particular, you need to understand the adjustments that will be made on each contract. For instance, if you are short CBA, you will be required to pay a ‘dividend adjustment’—an amount equal to any dividend paid by CBA during the period you are short (dividend adjustments may also, in some cases, include an amount to compensate for franking credits). As the CFD is intended to replicate a sale of CBA shares (for cash) you will be paid interest during the period you are short (although note our comments below about interest rates).
Counterparty risk. In the case of CFDs and forwards you are transacting with another party. Your ability to realise any profit on the contract (and any balance in your account) is contingent on them being able to pay you.
If you are dealing with a big four bank this is probably not a major concern, but you do need to be conscious of it with CFD providers. Some are owned by banks and large global institutions, but others are smaller privately owned enterprises. Remember also that even major global institutions are not immune from problems—consider the case of MF Global.
Slippage. Where you don’t have an exact match between your long and short positions you will run the risk of ‘slippage’—where the profits and losses on the contracts don’t move in sync. For example, if you enter into a short trade over the ASX 200 index, rather than immediately selling a portfolio of shares, the gains on the portfolio won’t perfectly match the losses on the short trade. The extent of the slippage will depend on the correlation between the portfolio and the index.
Tax. Tax is another potential form of slippage. A detailed analysis is beyond the scope of this article but be aware that, whilst two transactions may ‘offset’ each other, they may have different tax treatments. One might generate capital gains (and losses) and the other ordinary income, or one transaction resides in your SMSF and the other in your own name or family trust (although it is better to avoid this if possible).
Cost of leverage. CFDs are leveraged instruments. If you go ‘long’ your CFD provider is providing the leverage. If you go ‘short’ you are providing leverage to them. Unfortunately, they charge you a margin—applied to a base rate—in either case. This means if you are going ‘long’ you might be paying, say, 7% interest (the actual rate depends on a range of factors) and if you are ‘short’ they will be paying you 2% (or, if the margin is greater than the base rate, you might still end up paying).
Cost of leverage is unlikely to be a major issue on a short term trade but over a longer period it will add up.
- Margin calls. CFDs and futures are traded on ‘margin’—you post an initial margin (deposit) plus an additional amount each day to cover any unrealised losses. You need to make sure you are in a position to post this margin whenever it is called—or deposit additional cash in your account to cover potential margin calls. If a margin call is not met your counterparty will generally have the right to close out the contract.
Many investors put shorting, and derivatives generally, in the ‘too hard’ basket. ‘Life’s too short’ is a common response to their complexity and risks. That’s understandable.
But if you’ve got the time and inclination (and haven’t already) give them a chance. Why not set up a CFD (or futures) account and do a few small ‘test trades’ to get your head around them?
There may come a moment when you’re keen to take advantage of an inflated share price, or a collapsed currency, but your flexibility is limited and time is of the essence.