Going short stocks… How to implement it?
by Patrick Oberhaensli, on Aug 3, 2020 1:15:00 PM
Wirecard, a German financial services provider, got huge publicity in June 2020 after an abrupt share price crash. On June 18th 2020, we saw Wirecard’s stock prices sharply fall from 104 EUR to 36 EUR in one day. This crash was triggered by the revelation that there was about 2 billion EUR “missing” from their balance sheet.
Wirecard received so much media attention not only because it was a large index component coming from the Fintech domain, but also because journalists had been discussing problems with the company for quite some time. The case was made even more high profile when it was revealed that several big hedge funds made huge sums of money as they went short the stock, at the right time.
Short-selling is often considered high risk, or even taboo, but in all actuality, being able to go short (the exposure looked for) is essential for the investing purpose for a multitude of reasons. In this two part short selling article series, we will review why short selling adds value, starting with the practical ways to implement such type of exposure with a focus on equities.
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The difficulty of being a direct short seller…
A hedge fund manager would typically go short a particular stock by selling it (directly) and borrowing the necessary shares from a broker in order to deliver them on time: if an investor sells a stock, he/she must deliver it on settlement day. But this type of transaction is not always available for the private investor, it is certainly not the case for private investors in Switzerland. But this doesn’t mean it’s impossible for traders to gain the equivalent short exposure through other means.
One solution for private investors is through the use of the Contract-For-Difference (CFDs). Via this Over-The-Counter derivative, investors will get in one step their desired market positioning. Contrary to direct short selling which involves not only the naked selling of the shares (as the seller doesn’t own them) but also their borrowing. Since the shares sold must be delivered timely and properly, a CFD trade is very easy for private investors to implement. However, it should be noted beforehand that investing with CFDs typically involves some preliminary administrative tasks– especially in terms of trading risk and knowledge.
Going short a stock indirectly via CFDs
Through an advanced broker, private investors can trade CFDs on several thousands of single stocks on a large basis of markets allowing a real global perspective. It’s not uncommon then for investors to have access to more than 8’000 stocks. Of course, CFDs on main indices are also necessary for sophisticated investment strategies combining short single stocks and long market indices (allowing a spread play). Moreover, in comparison to futures, with CFDs, the investor can deal with small(er) amounts– also, futures are not met very often on individual stock names
There are two essential aspects of CFDs that need to be considered by the investor. One is the credit risk of the trading service provider. Since CFDs are Over-The-Counter transactions executed through a broker, the conditions will vary with each trading service provider. The second essential aspect is the transaction costs: the bid-ask spread needs to be competitive as well as the position holding costs.
Brokers usually share their particular conditions in regards to CFDs on their website, such as margins applied, but it is up to the investor to review the conditions thoroughly, especially considering that the conditions can rapidly change. Transaction total costs and cash needs are particularly interesting as a function of the leverage for traders when evaluating various brokers.
Investors should keep in mind that during specific times, there could be short selling restrictions applied on particular stocks in order to limit/stop a potentially dangerous (for the company) downside speculation. An example of a “typical” sector where these restrictions could be applied are banking stocks.
In terms of leverage, the margin could be at 15% or even lower for a good number of stocks (typically value stocks) allowing for a strong leverage effect (as with futures). But of course, the investor needs to be aware that single stocks have specific risks beyond the market risk (their beta doesn’t capture all specific aspects). In the case of a short position, the risk would be if the stock goes up a lot, very quickly… For example, we often see this happen with companies in the high-tech segment.
Investors who look to exploit the corresponding potential alpha of short exposures, should evaluate the individual (short exposure) offerings when selecting a broker or trading platform service for their investment. But even more important than the broker conditions, is the strategic support in the trading decision process that the investor can get from their broker. In our second part of our short-selling series, we will explore different ways for investors to identify opportunities to go short… and it is not at all similar to going long!
EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible