Going short - how to take advantage of falling markets

Short and long compared

Going short and long can be compared to a thermometer. If you don't have any position (so, only cash), then it's zero degrees and you are in the blue zone. Above zero degrees, you are in the positive territory, you expect prices to go up so you own positions and are long. Here you are in the green zone. Below zero degrees, you are in the negative territory, you expect prices to go down so you short positions, that is you are in the red zone.

A major difference between long and short is that with the former, the maximum an investor can lose is limited to the amount that is invested. On the other hand, with shorting, potential losses are theoretically unlimited

How to short ?

Shorting is a complex financial maneuver that often involves derivatives. Derivatives are products that derive their value from an underlying asset and the price movement in the underlying asset determines the price of the derivative. Products that are available to short the market include: CFDs, futures, inverse ETFs, options and turbos. Availability of these products might differ from region to region.

Note that derivatives are complex products which are only suitable for investors who understand the characteristics and risks of those products.

1. Using CFDs

CFDs can be used to short individual stocks. CFDs or contracts for difference are derivatives that allow investors to profit from price movements without owning the underlying assets. Profits and losses are determined by the difference between the entry and exit price of a trade. 

If for example you believe that company ABC share price will go down from its current $100, you could short sell 100 CFDs of company ABC at $100. If you are right and the price goes down, your profit is $5 per share or $500 in total (excluding commissions, financing cost and other fees). If on the other end the price goes up to $105, instead of a profit, you’ll suffer a loss of $500. As theoretically companies share price can go up to infinity, when shorting company ABC, your potential loss is unlimited. Note also that as CFDs are traded on margin, your profit and loss are magnified by the leverage ratio. 

Futures are often used to short major indices like the S&P 500. A future is an agreement where you agree on the price for a possible future delivery (or financial settlement) on the day of expiry. By buying a future, you create a long position. By selling the future you create a short position. Futures can be traded on a daily basis and do not need to be kept in your portfolio until maturity.

Let’s look at an S&P 500 mini future as an example. This future has a contract size of 50 times the index itself, which means that if the S&P is trading at USD 5,400, the S&P 500 mini futures is worth USD 270,000 (or 50X5,400).

Let’s say that your view is that the value of the index will fall to approximately 5,000 points. To profit from that, you will sell S&P 500 mini futures at 5,400. Let’s say you choose to short 5 mini futures. If your view is right and the index goes down to 5,000 points, you will have earned 400 points. Measured in dollars, your profit would be 400 points * 50 (contract size) * 5 (number of contracts) = $100,000. But be aware, by taking this position you would have created a short exposure of 50 * 5,400 * 5 = $1,350,000. Every percent the market rises will lead to a loss of $13,500!

Also be aware that entering a short position will lead to margin (a form of collateral). This is because there is no initial exchange of money if you sell (or buy) a future. There is just the agreement, and the financial settlement will be in the future. This means that you need to have enough capital in your trading account to be able to sell the future (enter the agreement) in the first place.

3. Using inverse ETFs

Another way of shorting the market is via an inverse ETF. A normal ETF tracks an underlying asset, most of the time an index. If the asset rises, the ETF will rise and vice versa. The inverse ETF works the opposite way. It will move – on a daily basis – in the opposite direction of the underlying index. So, if the underlying index declines, the inverse ETF will gain in price (and vice versa). This is also a method of shorting the market. If you buy an inverse ETF, you short that index.

Closely related to this is the leveraged inverse ETF. Here, there is a leverage component added to the inverse ETF, so the percent change in the underlying index will be multiplied by the leverage factor. Normally, that leverage factor is two or three times the daily percent change of the underlying index. For example, if the index falls 2%, the 2X leveraged inverse ETF will gain 4%, a non-leveraged inverse ETF will gain 2% and a regular ETF will lose 2%.

With put options, the buyer of a put option has the right to sell the underlying asset for a predetermined price (the strike price) for a predetermined period of time (until expiration). Buying a put option can be regarded as an insurance for an existing long position.

When an investor does not hold the underlying asset, a long put can be regarded as a way to short the market because a long put will increase in price if the asset falls.

There are put options available on individual stocks but also on most indices. This gives the investor the ability to create a short position where the premium paid for the put option is the maximum loss.

Let’s look at an example. Say the S&P 500 is trading at 5,400 and there’s a put option expiring in three months at USD 5,000, which trades around $130. Because the contract size of this option is 100, your initial investment would be $13,000. If the S&P 500 index falls to 4,800 in the first month, then the value of that put would be $200 (strike price of 5,000 minus actual level of the index at that moment, which we established was 4,800). In other words, you are entitled to sell for 5,000, while the actual price is 4,800. This sets the value of that right to be at least 200. Multiplying this by the contract size of 100, brings the value per put option to $20,000.

In short

Going short is a way to take advantage of falling markets, but it might not be for everyone. If you are a long-term buy-and-hold investor, going short is probably not part of your investment strategy. You may know that the opportunity exists, but you don’t put that knowledge into practice. If you are a more active trader, going short can add value to your strategy. After all, going short will benefit from a falling market. But beware of the risks involved with a short position, especially with leveraged products. In case the market does rise (and you lose money), it is important to maintain a strict risk management approach.

Investing carries risk. Your investment may decrease in value.