How to short stocks you think will fail

Savvy investors can make money from shorting, by buying an asset they consider overvalued and cashing in on its crash

Chinese e-commerce multinational Alibaba Group is one of the most shorted stocks in the world, as many investors believe they are overvalued and ripe for a plunge. Photo: Reuters

If you are really serious about investing, you need to understand both the long and the short of it.  Most investors instinctively know what going “long” on a stock means, even if they do not realise it.

This means buying a stock, fund, currency or commodity in the hope that its value will increase and you can sell at a profit, which is what the vast majority of investors do.

However, a select band will do the reverse and “short” an asset that they consider is overvalued and primed to crash, in order to make money from its misfortunes.

Gordon Robertson, director of financial advisory group InvestMe Financial Services in Dubai, says most people have heard of shorting stocks yet do not really understand what it involves.

“It means selling a stock that you do not actually own," he says.

Your broker borrows the share from another investor, which you then sell. When the stock falls – or rather, if it falls – you buy it back, bank your profit, and return the shares to their original owner.

“If you short a stock at, say, $100 and it falls to $70 then you have made a profit, while long investors have lost," Mr Robertson says.

There is a cost to this though, as you have to pay fees and interest charges for borrowing the stock. “This costs about 3 per cent a year, and you must hand over all the dividends as well,” he says.

Some online trading accounts such as etoro.com make the process quick and simple by giving investors a choice of "buy" and "sell" buttons, depending on whether they want to go long or short. Alternatively, you could try spread betting. In this case you do not actually buy the underlying stock, commodity or any other asset, but speculate on whether the price quoted by your online trading platform will rise or fall. For example, you could bet a dollar for every point an index, such as the FTSE 100, moves in either direction. Remember though, your profits can be outsize but so can your losses.

Mr Robertson says you could short an entire index with a specialist short exchange-traded fund instead. "For example, if you think the US stock market is set to fall you could buy the Pro Shares Trust S&P 500, which will replicate any decline."

This could offset losses in your long portfolio in a stock market crash and there are plenty more short ETFs to choose from.

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Mr Robertson warns that shorting individual stocks is fundamentally riskier than going long. “If you own a stock, you can only lose money you have actually invested, whereas if you go short and it rises instead of falls, your potential losses are unlimited.”

Plenty of traders and fund managers are constantly shorting stocks and their activities can tell you a lot about investor sentiment towards holdings in your portfolio.

Sometimes investors gang up on a company because they reckon things are going awry, and they hope to take advantage. Electric car vehicle manufacturer Tesla and Chinese e-commerce multinational Alibaba Group are now two of the most shorted stocks in the world, as many investors believe they are overvalued and ripe for a plunge. Both have been volatile, although neither stock has collapsed yet. Tesla chief executive Elon Musk is being sued by shareholders who accuse him of manipulating the price of his stock with series of tweetslast month that ambushed short-sellers who were betting against his company over production delays.

Vijay Valecha, chief market analyst at Century Financial Brokers, says a large short position can warn of trouble ahead. "This could be due to problems with the company, the industry as a whole, or even the broader stock market."

He says you should not necessarily shun a heavily shorted stock, it could even be a contrarian buy. "The first step is to evaluate the company's fundamentals, to see whether the short position is justified. If you think it isn't, you could still buy but with an added degree of caution.”

Long investors can even benefit from something called a "short squeeze", which happens where a stock soars rather than plunges, forcing short-sellers to cut their losses by repurchasing the stock. "If many do this at the same time, it can turbo-charge a huge rally," says Mr Valecha.

He adds that short-sellers recently came unstuck with UK-listed online supermarket Ocado, which slipped after investing heavily in online grocery delivery technology, then rebounded as other companies rushed to sign partnership agreements to use its systems. “One year ago, almost 17 per cent of Ocado’s shares were being sold short," says Mr Valecha. "The share price is up 280 per cent since then, costing short investors a fortune.”

That will not deter investors from looking for fresh shorting opportunities, Mr Valecha adds. “US cable television companies such as Comcast and Dish Network are interesting many, as they are losing market share to internet streaming companies such as Netflix.”

Jordan Hiscott, chief trader at Ayondo Markets, says you should not sell a stock you hold simply because other investors are rushing to short it, but the activity should alert you to a potential problem. “As Ocado has shown, short sellers aren’t always right. You need to work out why they are doing it. For example, has there been a change to the company that you have missed?”

Be warned, the largest companies often have the largest amount of short positions.

For example, in April Apple was the second most shorted stock on the US market after Tesla, but it has soared since then.

Steve Clayton, who runs HL Select Fund Manager for UK fund manager Hargreaves Lansdown, says there is no such thing as a surefire short, although several years ago investors thought they had found one.

The Swiss National Bank had a policy of capping the Swiss franc to keep a lid on its value against the euro and some traders saw this as a one-way bet. “When the franc was close to its upper limit, they placed bets it would fall as the SNB intervened to defend the cap.”

Then in January 2015, the SNB scrapped the cap, and the Swiss franc flew. “Short investors incurred instant losses on a grand scale, in a matter of moments.”

Others have also come unstuck. In 2012, hedge fund manager Bill Ackman at Pershing Square Capital, shorted Californian nutritional supplements company Herbalife with the stock at $45 after claiming it was a pyramid scheme and would go to zero.

In March this year, Mr Ackman finally exited all his positions with the share price at $92. An estimated loss of $1 billion.

Traders can make big money by betting against assets they think will fall, but they can also lose it in short order.