How to safely "short" the markets

Highlights in this issue:
• Shorting shares and betting against bear market rallies...
• Getting pinched by short squeezes...
• Reduce your short risk through puts... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

Ever wondered how to make the most from a falling market without taking on huge risks? Well, today's issue of Investment Academy is for you. One of my colleagues, Karim Rahemtulla, from our sister publication in the States is with us today to tell you exactly how to do just that. So without further ado, here's how to "safely short the markets"...

"Investors are worrying that a three-month surge in stocks might be overdone."

So read a piece of market commentary from the Associated Press a few days, as the Dow, S&P 500 and Nasdaq all slumped.

Thanks for the heads-up, guys. You're about two months too late. Bear market rallies are fun while they last. But they're only temporary. And the last week of sharp sell offs reminds us that the market has an uncanny knack of sucking the wind out of your sails when you least expect it.

Far from being gloomy, it also reminds us that there's just as much opportunity to make money from the downside as the upside. But you need to do it the right. Here's how to profit from market pullbacks and protect yourself in the process.

Don't get sucked in by a short sell

When you're bullish on the market or a share, you go long. When you're bearish, you go short.

Shorting can spell great risk and danger for rookies - and many professionals.

Many investors believe that the best (and sometimes the only) way to make money from a falling market or share is to "short" it. So let's quickly go over the mechanics of how shorting works...

• You sell shares of an asset into the market before buying them. Because you're anticipating a drop in price, you're hoping to buy the shares back at a lower price once this happens. Short sellers sometimes aren't popular because they're hoping the market and/or share goes down.
• You go short by "borrowing" the shares from someone who's long on the asset (you don't own the shares when you go short) and hope that it tanks. So when you buy the shares, you're essentially replacing the shares you borrowed.
• If you're right and the asset falls, you profit because the shares you buy back are cheaper than when you borrowed them.

But what if you're wrong and the asset rises? The real danger is that a share - theoretically - could go to any price and you'd be stuck with the difference.

The short squeeze: On the wrong side of a trade

It's the nightmare scenario.

You short an asset you're convinced is about to decline, but it turns the tables on you and rises instead. You're now on the hook to buy the shares at a higher price than you borrowed them - you're on the wrong side of a short squeeze.

A short squeeze puts short sellers in a losing position, faced with the prospect of unlimited losses as the asset rises. The more people who went short, the more severe the reaction will be.

In a panic, they all pile into the share at the same time, trying to buy them back to cover their trades and get out of them. This is known as short covering. The buying demand, coupled with the lack of sellers drives the price up even more, thus adding to your unlimited losses.

For example, let's say you shorted 1,000 shares of Anglo America (JSE: AGL) at R170 where it was three months ago. That would have given you R170,000 exposure. But you'd still have to replace those shares eventually because you only borrowed them.

But Anglo American has performed very well over the past three months and is trading around R220 today, so if you hadn't covered your shares till now, you're forced to buy them back for R220,000 - at a loss of R50,000. And the more the share rises, the more you lose on your original investment.

You never want to be in this situation, period. Here's an easy way to make sure that you're not on the wrong side of unlimited short losses again.

How to lower your short risk

If you think an index or share is set for a fall, buy put options on it. This allows you to play the downside, but with far less risk than if you shorted the share.

When you buy a put, you have the right, but not the obligation, to sell the shares. That means your loss is only limited to the amount you pay to buy the option contract if the asset rises. No more. And if it falls, your put makes money.

For example, let's say that instead of shorting Anglo shares, you'd bought put options instead. You'd only lose the money you put down to open the trade, nothing more. Retail options are available to trade on the JSE - speak to your broker to see if they provide options trading.

Short selling can be extremely profitable if you're right... but a very risky strategy if you're wrong because your losses are unlimited.

So keep an eye out for stocks that are overpriced and ripe for a decline, or economic/company news that could drag them down. And if you want to play the downside, do it with put options.

Good investing,

Karim Rahemtulla

P.S. If you're desperate to know more about trading options, click here for more information.