What is ‘shorting’ the market?

by Dec 30, 2016

Trading the markets: What is long and short trading?

Trading on a market can be said to be similar to gambling. How? Trading is heavily focused on predictions. When you put down 10 pounds at a bookmaker on a horse, a football team or a tennis player, you are making a prediction on the success or failure of these in any given arena, whether it be a race, individual game or tournament. In the stock market, you are similarly predicting whether a business will perform well or badly over a certain length of time and knowing when to short the market can be a big advantage.

Within the stock market, trades can be broken down into long and short trades. In simple terms, a long trade is where you invest with the intention of profiting from a market that is rising. A short trade is when you invest with the hope of making profit from a market that is falling. To put it into business jargon, a long position is bullish (when markets are rising) and a short position is bearish (when markets are falling). Shorting a stock is the diametric opposite of buying a stock.

The Bear and Bull in front of Frankfurt’s stock exchange – symbolizing the opposite extremes of market movements

How to short the market?

Short selling is the borrowing and selling of a stock, with the hope of buying it back later at a cheaper price. A trader, acting on behalf of themselves, a company or a client, thinks that the price of shares in a company will go down, so in order to make a profit from this prediction, they decide to short them. In short selling, you start by borrowing shares (usually from a broker). You then owe them for borrowing. You (or the broker) sell those shares that you borrowed on the open market (stock market) to other investors for the price they were valued at the time and thus you are short the market.

Let’s use the example of a business and call it Company A. Let’s say Company A’s share price was on the market at $50 a share, but perhaps you see a scandal involving management on the horizon that might reduce the price. You estimate they will drop to $40 a share. You (or the broker) sell the shares borrowed at the market price, (lets say it was 1 share) on the open market. Since at the time they were worth $50 per share, and you have 1 share, you make $50 and it goes into your account. A week goes by and your prediction was right, suddenly Company A is in the headlines for a scandal and investors are losing interest. The share price slides and it eventually get’s down to $40. You then close the short position and buy the same share for $40 on the open market – making a $10 profit. Why did you profit? You sold Company A stock for $50 and bought it back for $40, hence you are up. You do also have to pay a small fee to a broker for providing services.

Show me a real-world example

During the run up to the 2008 financial crisis, few foresaw the damage that America’s housing market would suffer, which came in part as a result of the misselling of loans to customers who could not pay their mortgages. Not only this, but financial institutions were bundling up these loans into complex financial instruments, then selling them on to investors, even though they knew they were ‘subprime’ (essentially – junk).  A huge bubble grew as the housing market became overly inflated, and the result, as we now know, was catastrophe. However, some traders recognized the warning signs early enough to make huge profits from shorting the market using instruments called ‘credit-default swaps’, a kind of hedge or insurance policy in case of widespread defaults by mortgage owners.

The Big Short – Michael Lewis’s book on the subprime crisis became a Box Office success

The author Michael Lewis explained the subprime crisis in his book ‘The Big Short: Inside the Doomsday Machine’, which was subsequently made into a film starring Ryan Gosling, Christian Bale, Brad Pitt, Steve Carell and others, as the ‘outsiders’ (based on real people) who saw the crisis coming.

They predicted that the market was heading for a fall which is when you should short the market, which is exactly what short trading involves, hence the film’s title. Barely any investors understood the extent of the problem, because the securities that the banks were trading and selling to investors were rated very highly by ratings agencies, meaning they thought their investments were as safe as houses. The ‘outsiders’ who realized the problem were able to make huge profits by betting against a market which was deemed to be very strong and stable, underpinned by a robust US economy which had been growing well.

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