Definition: selling securities you do not own in the hope of buying them
back at a lower price in the future and pocketing the difference.
Example
John thinks shares in XYZ Plc are going to fall from their current price of 450p.
He enters a contract to sell them at 450p in three months time. The price falls from 450p to 400p after three months.
He buys the shares at 400p making an 11% profit (450 – 400 = 50 / 450).
If his bet was for £10 per point, the profit would have been 50 x £10 = £500.
With shorting, the risk is that the price moves upwards during the time period of the bet.
In the example above if the price rose to 480p, John would have had to close his bet by buying at that price. His loss would then have been 30 points (450 – 480) and, assuming that the bet was for £10 per point, he would be down £300.
In ordinary share trading, there has always been a psychological barrier to shorting. ‘Selling something you do not own’ was felt to be improper, almost unpatriotic, and somehow not in the spirit of investing.
This hostility is quite irrational, since ‘shorting’ is an everyday part of many business transactions. When you pre-book a turkey for Christmas, the butcher is effectively selling short – selling something which he does not yet own.
Spread betting strategies
If you buy a house on a greenfield site from a property developer when all the company has at that time is a block of land and a building plan, the property developer is selling you a house that does not exist yet. You should dismiss the thought that shorting is an unorthodox way of trading, or a kind of exotic activity reserved for hedge funds and sophisticated traders. It isn’t. It is simply the reverse side of going long, and a way to back your view that a price is likely to go down.
Think of it this way:
– If you only ever go long on shares (buy before you sell), you can only make money from price advances.
– If you have shorting in your armoury, you can profit from price falls as well.
As we all know, markets can fall as well as rise, so it makes sense to be as comfortable going short on the markets as you are going long. In spread betting, shorting is equivalent to placing a sell on a market. The way you profit is exactly the same way as when you buy. If the price falls by 10 points then your profit is 10 points multiplied by your stake.
Example
John walks into a branch of a listed hardware company – Hammer Co. – and notices that there are less people lining up to buy items from the store than in previous weeks. John follows the shares of Hammer Co. and remembers that the company is due to release a trading update in a few weeks.
He predicts that Hammer Co. will lower their sales targets based on his research and what he witnessed at the branch. He places a down bet at £50 per point at 130p.
As he rightly predicted, Hammer Co. announced weaker than expected sales over the latest quarter. The share price falls to 110p and John makes a gain of 20 points (130p-110p) x £50 = £1,000.
The Beginner's Guide to Financial Spread Betting
Hedging
Definition: hedging is protecting an existing holding or asset, should it
fall in value, by making an equivalent investment that offsets or reduces potential losses. This allows you to leave your share holding undisturbed in the event of an unexpected price fall.
Spread betting is often used to hedge a physical share portfolio against short-term falls in the market.
It is much cheaper to do this than to sell the entire portfolio and buy it back at a later stage.
Example
John owns a portfolio of mainly FTSE 100 shares with a total value of £60,000.
He thinks the FTSE 100 index is going to fall. He could back his judgement by selling his shares, waiting for the market to fall, then buying them back at the lower price. The problem for John is that he has large gains on his portfolio, and if he sells the shares, a capital gains tax charge will arise.
An alternative is to hedge his portfolio against a fall by selling the FTSE 100 index short. The idea here is that if the FTSE does fall as expected, any drop in the value of the individual shares in John’s portfolio will be offset by profits he makes by going short on the index. Let’s say that John takes the spread betting route and see what the effect would be:
Action: He sells £10 per point of the FTSE 100 future at 6000 points, when the quote on the index is 6000 – 6005.
Spread betting strategies
Scenario 1: The FTSE 100 drops by 10% to 5400
Assuming that John’s individual shares all fell by the same % as the index, his portfolio would drop in value by £6000 to £54,000.
– If John closes his spread bet by buying the FTSE 100 Future at 5,400, his gain would be (6000 – 5400) x £10 = £6,000.
In other words, his portfolio losses would be matched by profits from his short position.
Scenario 2: The FTSE does not drop, but stays at 6000
– If the FTSE does not fall as John expects, but stays at 6000, and assuming that his individual shares reflect the index, his share portfolio would be unchanged in value at £60,000.
– When John comes to close his short position by buying back the FTSE 100 Future he will have to do so at the higher side of the spread, let’s say 6005. His loss of the spread bet will be limited to the spread of 5 points x £10 = £60.
Scenario 3: The FTSE does not drop, but rises to 6200
– If John’s prediction is completely wrong and the FTSE rises to 6200, his share portfolio will rise in value in proportion to a value of £62,000.
– His losses on the spread bet will be approximately the same. He will have to buy back the FTSE at 6205, and will make a loss of £2,050 (£10 per point on the difference between 6000 and 6205).
There are several key points to note about this hedge:
1. Because it was set up as a counterweight to John’s share portfolio, whatever the market did (whether it went up, down or sideways), his overall position was largely unaffected. The hedge kept him in a market-neutral position.
2. It enabled John to take precautions against a market fall without actually selling his shares and incurring capital gains tax.
The Beginner's Guide to Financial Spread Betting
3. The price of that insurance was low. In the situation where the FTSE did not move, John’s cost was just £50. He may have been wrong about the FTSE, but having the hedge in place gave him peace of mind on his share portfolio and, at just £50, he may have felt that that was worth paying.