How to make money in a falling market: short selling

Susan
By Susan March 28, 2012 09:35

How to make money in a falling market: short selling

 

 

You might remember how, in late September, a “trader” going by the name of Alessio Rastani was interviewed by the BBC. One of his highly dubious statements was referring to Black Tuesday, October 29, 1929, at the beginning of the Great Depression: “People were prepared to make money from that crash, and anybody can do that, it isn’t just for the elite.”

 

Now that you know why I needed to vent a bit, I want to tell you what it really takes to make money in a downward market. Spoiler alert: it’s slightly more complex than Mr. Rastani would have you believe.

 

 

What is short selling?

 

Short selling, also known as “shorting the market”, is a strategy that you can use when a stock is falling.

 

You borrow a stock from someone, you sell it, you wait for it to fall some more, and you buy it again, at a lower price. Then, when you’ve bought the stock back, you return it to their owner and you pocket the difference between the price at which you sold and the lower price at which you bought back the stock.

 

In order to do this, you need to set up what is called a margin account. Indeed, as you are borrowing from somebody, there are rules and monitors in place to ensure that you can make good on your agreement to give back. For example, you must deposit a certain percentage of the money you intend to trade – in essence you need to prove that you can buy some stock in the open market to actually return it to the lender.

 

But there is one big caveat.

 

 

Stocks are not just abstract concepts

 

Stocks are shorthand for “bits of a company”. When a company goes public, it divides up its value in smaller parts, in order to be able to sell those parts (the shares) to people who will then de facto become owners of the company.

 

When you’re buying a stock you’re actually buying somebody’s company.

 

Let’s take the example of my company. We set it up so that it would grow and flourish. In addition, we anticipated that we could make a higher return on our own investment of funds than if we put the money into the bank.

 

If we thought anything to the contrary, if we thought we were going to lose all this money, time and effort, why bother to create that company in the first place?

 

The stock market is made up of a huge volume of businesses with the same attitude! Nobody sets up a business to fail. This means that, over the very long term, say, fifty or a hundred years, the value of the stock market has to rise.

 

Of course, there are bubbles and downturns along the way, as well as a host of economic factors involved, but this doesn’t change the fact that the whole of our capitalist system is based on this very idea: “If I create a company, it’s because I think it has an extremely high chance of doing well and increasing in value.”

 

 

The market cannot fall forever

 

As a result, if the market falls, it is not going to go on forever. If it did, all businesses that comprise the stock market would fail. I don’t see that happening.

 

Indeed, as long as businesses provide valuable services, they will have customers who will buy from them – this will increase the value of the company, and therefore the value of owning it. So if you own a share of a company that provides value, this share or stock will go up and you will be one happy shareholder.

 

Consequently, if you are going to make money when the market is falling, you need to be very vigilant because essentially, you are swimming against the tide of capitalism. And that only lasts for relatively short periods, typically months.

 

Please note that I am not talking about the worldwide economic recession here, but about the downs of the stock market – they are two very different things.

 

And it can be a costly lesson to get the two mixed up.

 

So if you are betting on a stock to go down, you are expecting something that is not within the natural progression of things. Not to say that it’s impossible, far from it. We see it happening every day.

 

But if a stock is losing value it means something is wrong: either the company is suffering in some way or the stock was overvalued to begin with. Short selling means you have to make a profit before this trend reverses and the stock goes up again.

 

 

No limit to your potential losses

 

This can only be a short-term strategy. Especially as there is no limit to your potential losses.

 

Indeed, when a stock goes down, the lowest it can go is zero – it could disappear for some reason, the company could be nationalised, etc. The most you can lose if you own a falling stock is: all of the money you invested in that stock, that is, 100%. So there is a limit to your loss.

 

I know, it does very little to comfort hapless owners of such stocks… But essentially it means they can only lose as much as they have – and not more than they have!

 

In short selling on the other hand, you are expecting the stock to go down. But what if, instead of falling, the stock rises between the moment you sell and the moment you buy again? There is no limit to that.

 

The stock could go up and up without a ceiling to contain it. And remember, to short the market you borrowed the stock – you can’t just walk away, you have to return the stock to its owner. And to return the stock you have to buy it back. So you might lose much more than “all” of the money you invested in that stock.

 

You might also lose money you never had in the first place, as there is no maximum loss.

 

Short-selling is a short-term, risky strategy. And yes, you could make money in a downward market with this strategy, and many people have. But you need to have your eyes wide open and have a deep understanding of the impact of any change in price… up or down.

 

Personally, I don’t like it – I don’t want to put myself in a position where my potential loss is uncapped.

 

Still, there is a way to make money in a falling market AND cap your loss. And it’s the topic of the next post. If you’re interested in reading on, sign up to The Positive Economist newsletter to receive an email update when the new article is published!

 

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Susan
By Susan March 28, 2012 09:35