Short sellers – those who try to profit from the price of shares or other assets falling – have long been convenient scapegoats for politicians to distract from their own economic mismanagement. Last week, the European Union (EU) launched its first set of pan-European rules on short selling, after claims that the practice exacerbates share price falls and causes unnecessary volatility. But what do short sellers actually do? And can you copy them?
Short sellers borrow stock, sell it, then buy it back before returning it. Imagine you could borrow 10,000 shares priced at £1 each, sell them for £1 each, then buy them back a few days later for 80p and return them. You’d have made a profit (ignoring transaction costs) of around 20p each or £2,000.
The EU has imposed tough new disclosure rules on anyone who does this to EU-listed shares or bonds. The EU has also cracked down hard on ‘naked short-selling’ – which is selling an asset without actually borrowing the shares first – and it has effectively banned certain types of downbet against sovereign debt.
We think this is all somewhat overblown. Given Europe’s woes, it’s small wonder that short sellers have spent so much time looking for targets on the continent. Short sellers don’t create bad companies or bonds, they merely identify them more rapidly than other investors – indeed, in many ways they do markets a favour.
They also take pretty big risks in doing so – while shorting can be very profitable, if you get it wrong, your losses are potentially unlimited. So it’s a perfectly valid investment activity. Trying to regulate the area will be tough, unless other regulators, particularly in the US, follow the EU’s lead.
Given the volatility of the current market, you might be tempted to try to profit from shorting yourself. But you have to be careful. Actively managed ‘long/short’ funds that place downbets are usually expensive, and many are closed to small investors.
Another option is to use inverse exchange-traded funds (ETFs). These are designed to fall by 1% for every 1% rise in a chosen index. But because they are priced on a daily basis, they are only suitable for short-term bets.
For example, say an index falls 10%, from 1,000 points to 900, then rises by 20%, to 1,080. An inverse ETF priced at 100 on the other hand, will rise 10% (to 110) and fall 20%, so it ends up at 88. So even although the index is only up by 8%, the ETF is down 12%.
That leaves spread bets. These are fast and cheap to place, but highly risky. If you’d like to know more about spread-betting techniques, sign up for our free MoneyWeek Trader email.