Full Version: Shorting
Can someone explain the principles and process of ‘shorting’ a company’s shares? I have heard about people invested in NR making fortunes by doing so and am curious how this works, particularly in today’s climate.
Come on then you financial wizards, explain!
We bumbled through a thread on this back in February:
http://www.housepricecrash.co.uk/forum/ind...defair&st=0
Be careful and informed.
Here be dragons...
http://www.housepricecrash.co.uk/forum/ind...defair&st=0
Be careful and informed.
Here be dragons...
The principle behind 'shorting' is that you borrow shares in a company from a shareholder, sell the shares, and sit on the cash (which is held as collateral). Then buy the shares back at a later date to repay the loan. You supplement the collateral with your own cash, to keep the LTV at an appropriate level.
Catches with this are that the shareholder expects the shares back (and will also expect any dividend payments). So if you're short a share that pays a dividend, you've already sold the share so you get nothing, so you need to pay the dividend out of your own pocket to the lender. The lender may also recall his shares (e.g. if he wants to sell them), at which point your broker will buy them back automatically on your behalf, at the prevailing price. Although your collateral cash will earn interest, you need to pay a small lending fee to the original shareholder, and a commission to your broker - so there isn't usually much interest left over (if any).
Most shorting in the UK is done through a type of derivative called a 'contract for difference' or CFD, or through a financial spread-bet. The two products are fundamentally very similar: they are private bets between you and a financial company - you don't deal in the shares directly, you don't borrow anything yourself, you don't hold any cash yourself, you have no legal connection to the company whose shares you are speculating on (whether short or 'long'). If you're 'long' in shares in a company, unlike if you held real shares, you have no shareholder rights to attend meetings/vote, etc. Additionally, the supplier of the CFD/spread bet need not actually place the trade in the market. Different suppliers have different policies - some always make the underlying trade, some study client's performance - if the client is making a lot of money, they'll make the trade; if they're a clueless newbie, who's haemorrhaging cash every trade, they won't bother and use the customer's losses as their profit.
The key difference between CFDs and spreadbetting are the tax implications and the transparency:
CFDs are taxed as financial products, so qualify for capital gains tax. Spread-bets are classed as gambling where winnings are tax free. (However, spread betting debts are not classed as gambling debts, and are fully enforceable).
CFDs are designed to be traded just like shares. The supplier of the CFD will quote market prices (sometimes an additional spread), and charge a fixed commission, just like you were buying real shares. High end providers, will give you access to the underlying stock market order books, and will trade your CFD at that exact price - potentially this is a totally open system. If the share pays a dividend (the dividends is paid out as cash to 'longs'; shorts have to pony up the dividend cash). CFDs also have the life of a share - you can usually keep a CFD open, as long as your account is funded, as long as the shares are traded.
Spread bets are based upon the futures market price of a share (or your bookie's quoted price) rather than the price of shares in the open market. Dividends aren't paid/charged, instead the futures price usually incoroprates a correction for the expected dividend (which provides a similar type of effect). Spreadbets also have a finite length - e.g. You'd make a FTSE100 July bet (the price quoted when you make the bet, will include expected dividends - and the bet will terminate on the 31 July). Spread bets are traded as a 'stake per point'. E.g. You'd place a Tesco shares July bet at £1 per point - this would pay out £1 for every fraction of a penny that the share price changes. If the shares cost £4 each - a £1/point bet would be equivalent to buying (or shorting) £4000 of shares. Typically there is no comission to pay for spread betting. The bookie's cut comes from the spread. Interestingly, the spreads may be narrower than equivalent CFDs.
In both of these cases, as with true shorting, there is the risk of unlimited losses. E.g. you short 10000 shares in ABC Pharmaceuticals when their share price is £1, with a deposit of £500. The next day, they discover the cure for cancer, and their share price explodes to £1000 per share. Not only have you lost your £500 stake, but you now owe £9,999,500 pounds. You'd hope that your supplier would terminate your bet before it got to that stage, but if the market 'gaps', there's not a lot you can do. Some CFD providers and bookies offer 'guaranteed stop loss', or 'controlled risk'. You pay a premium for this service, but if your bet loses, it is guaranteed to be be terminated at a pre-arranged loss, regardless of market conditions.
A better option may be the use of warrants. A warrant is an exchange traded derivative, analagous to 'options' traded in the USA. A warrant gives you the option to buy or sell the underlying share at a pre-defined price on a pre-defined date. These are called 'calls' and 'puts' respectively. A call is a way of betting on a rise in price. A put is a way of betting on a fall in price.
E.g. Tesco shares are trading at £4.99. You want to bet that the price will fall. You buy a £5 put Dec 2008 warrant for 20p. The price of Tesco shares falls to £4.50 in December. The warrant allows you to sell a share for £5, but market price is £4.50. In practice, your broker will simply cash out your warrants for the difference (in this case 50p). If the price of tesco shares had risen or stayed flat, your warrants would be worthless - but there is no other liability. Your maximum possible loss is limited to your inital stake. Warrants can be traded just like shares, so they can be bought or sold at any time - and their market price tends to reflect the value of the share (but it doesn't track it exactly - as the price of warrants varies in a complex way, depending on how much longer they have to their expiration date, etc.)
There are a number of market makers (notably Societe Generale and Goldman Sachs) who create warrants for trading on the London Stock Exchange. You can buy or sell these just like shares through a standard stockbroker account (however, not all stock brokers offer warrant trading. E.g. Selftrade do offer them. Iweb don't - and you may need to submit a document acknowledging the risks inherent in derivatives trading before your broker will allow you to trade them).
Catches with this are that the shareholder expects the shares back (and will also expect any dividend payments). So if you're short a share that pays a dividend, you've already sold the share so you get nothing, so you need to pay the dividend out of your own pocket to the lender. The lender may also recall his shares (e.g. if he wants to sell them), at which point your broker will buy them back automatically on your behalf, at the prevailing price. Although your collateral cash will earn interest, you need to pay a small lending fee to the original shareholder, and a commission to your broker - so there isn't usually much interest left over (if any).
Most shorting in the UK is done through a type of derivative called a 'contract for difference' or CFD, or through a financial spread-bet. The two products are fundamentally very similar: they are private bets between you and a financial company - you don't deal in the shares directly, you don't borrow anything yourself, you don't hold any cash yourself, you have no legal connection to the company whose shares you are speculating on (whether short or 'long'). If you're 'long' in shares in a company, unlike if you held real shares, you have no shareholder rights to attend meetings/vote, etc. Additionally, the supplier of the CFD/spread bet need not actually place the trade in the market. Different suppliers have different policies - some always make the underlying trade, some study client's performance - if the client is making a lot of money, they'll make the trade; if they're a clueless newbie, who's haemorrhaging cash every trade, they won't bother and use the customer's losses as their profit.
The key difference between CFDs and spreadbetting are the tax implications and the transparency:
CFDs are taxed as financial products, so qualify for capital gains tax. Spread-bets are classed as gambling where winnings are tax free. (However, spread betting debts are not classed as gambling debts, and are fully enforceable).
CFDs are designed to be traded just like shares. The supplier of the CFD will quote market prices (sometimes an additional spread), and charge a fixed commission, just like you were buying real shares. High end providers, will give you access to the underlying stock market order books, and will trade your CFD at that exact price - potentially this is a totally open system. If the share pays a dividend (the dividends is paid out as cash to 'longs'; shorts have to pony up the dividend cash). CFDs also have the life of a share - you can usually keep a CFD open, as long as your account is funded, as long as the shares are traded.
Spread bets are based upon the futures market price of a share (or your bookie's quoted price) rather than the price of shares in the open market. Dividends aren't paid/charged, instead the futures price usually incoroprates a correction for the expected dividend (which provides a similar type of effect). Spreadbets also have a finite length - e.g. You'd make a FTSE100 July bet (the price quoted when you make the bet, will include expected dividends - and the bet will terminate on the 31 July). Spread bets are traded as a 'stake per point'. E.g. You'd place a Tesco shares July bet at £1 per point - this would pay out £1 for every fraction of a penny that the share price changes. If the shares cost £4 each - a £1/point bet would be equivalent to buying (or shorting) £4000 of shares. Typically there is no comission to pay for spread betting. The bookie's cut comes from the spread. Interestingly, the spreads may be narrower than equivalent CFDs.
In both of these cases, as with true shorting, there is the risk of unlimited losses. E.g. you short 10000 shares in ABC Pharmaceuticals when their share price is £1, with a deposit of £500. The next day, they discover the cure for cancer, and their share price explodes to £1000 per share. Not only have you lost your £500 stake, but you now owe £9,999,500 pounds. You'd hope that your supplier would terminate your bet before it got to that stage, but if the market 'gaps', there's not a lot you can do. Some CFD providers and bookies offer 'guaranteed stop loss', or 'controlled risk'. You pay a premium for this service, but if your bet loses, it is guaranteed to be be terminated at a pre-arranged loss, regardless of market conditions.
A better option may be the use of warrants. A warrant is an exchange traded derivative, analagous to 'options' traded in the USA. A warrant gives you the option to buy or sell the underlying share at a pre-defined price on a pre-defined date. These are called 'calls' and 'puts' respectively. A call is a way of betting on a rise in price. A put is a way of betting on a fall in price.
E.g. Tesco shares are trading at £4.99. You want to bet that the price will fall. You buy a £5 put Dec 2008 warrant for 20p. The price of Tesco shares falls to £4.50 in December. The warrant allows you to sell a share for £5, but market price is £4.50. In practice, your broker will simply cash out your warrants for the difference (in this case 50p). If the price of tesco shares had risen or stayed flat, your warrants would be worthless - but there is no other liability. Your maximum possible loss is limited to your inital stake. Warrants can be traded just like shares, so they can be bought or sold at any time - and their market price tends to reflect the value of the share (but it doesn't track it exactly - as the price of warrants varies in a complex way, depending on how much longer they have to their expiration date, etc.)
There are a number of market makers (notably Societe Generale and Goldman Sachs) who create warrants for trading on the London Stock Exchange. You can buy or sell these just like shares through a standard stockbroker account (however, not all stock brokers offer warrant trading. E.g. Selftrade do offer them. Iweb don't - and you may need to submit a document acknowledging the risks inherent in derivatives trading before your broker will allow you to trade them).
Alternatively, if you want an easier way to short stock market indicies or commodities, look for ETFs that allow you to do this (search for ETFS or iShares). My stockbroker Hargreaves Lansdown has a good collection of them.
I like the ETFs as you can go short/long in most of them so you can ride stocks up and down.
A word of warning though - shorting is dangerous - if the stock doubles, you lose all your money! With ETFs you don't lose more than your initial investment though.
A safer strategy is to wait for a stock to recover, then go long. Banks, airlines, retailers, housebuilders will almost certainly recover
.
I like the ETFs as you can go short/long in most of them so you can ride stocks up and down.
A word of warning though - shorting is dangerous - if the stock doubles, you lose all your money! With ETFs you don't lose more than your initial investment though.
A safer strategy is to wait for a stock to recover, then go long. Banks, airlines, retailers, housebuilders will almost certainly recover
.
Is spread betting tax-free for a company too? Or just an individual?
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