Investors looking at today's nausea-inducing market plunges may be tempted to contemplate short selling equities to make a killing in the market.
The trouble is, short sellers can just as easily be killed. Most advisers have a message for average retail investors building a nest-egg or preparing for imminent retirement: don't.
"For 99.9 per cent of investors, short selling as an investment strategy is a bad idea," says George Christison, retirement and financial planner and founder of British Columbia-based IFM Planning Services.
"I think the stories about making a killing from shorting are no different than the stories about people winning the 6/49 lottery or a million dollars at Vegas."
The strategy has been glamourized in the Oscar-nominated movie The Big Short, based on author Michael Lewis's bestselling book. Mr. Lewis and the movie chronicled how a small group of traders analyzed the U.S. subprime mortgage market as it soared in the middle of the past decade.
The traders realized that securities being gobbled up by major banks and investment houses around the world were based on U.S. mortgages that had a good chance of defaulting, plunging the securities. So they used billions of dollars to bet this would happen.
They were right – the market crashed in 2008 and these traders won big, while nearly everyone else lost.
Strictly speaking, the strategy they used was a more complicated variation on short selling; movie watchers might remember it being explained by actress Margot Robbie in a bathtub scene. But it was similar in that The Big Short trades made money on a price decline, using borrowed funds.
The basic procedure to short sell a stock is that the investor starts by borrowing shares at a given price from an investment dealer or broker. For example, the investor may borrow 100 shares at $10 each, worth $1,000, and then sell them on the open market at that price.
The investor borrows these hoping and expecting that the price of the shares will go down, not up. If this happens – say the value goes down to $500 – the investor still owes the dealer the 100 shares that were borrowed. He or she buys them, now for $500, gives them back and keeps the remaining $500 as profit.
"This is how the strategy works when it works. While it can be a legitimate strategy, it's inherently speculative," says Toronto-based financial author Sandra Foster.
Unlike an investor who simply buys a stock and can be patient if it takes time to go up, perhaps collecting dividends, a short seller is speculating that the investment will definitely go down before the deadline set to return the borrowed shares. If the stock goes up, they not only lose, they can lose big.
"The worst thing that can happen when you go long [buy investments] is that your holding can go to zero. When you short a stock and it goes up, your potential loss is unlimited," says Dan Bortolotti, investment adviser at PWL Capital Inc. in Toronto and the blogger behind canadiancouchpotato.com.
Despite being so risky, short selling "has gathered interest with equity markets trading down since the beginning of the year," Ms. Foster days. Anyone interested in how much a particular Canadian stock is being shorted can visit the Investment Industry Regulatory Organization of Canada's (IIROC) website, which publishes a bimonthly spreadsheet called the Short Sale Trading Statistics Summary.
Almost all advisers counsel individual investors not to try short selling unless they have very sophisticated market knowledge or are working with a professional adviser. But shorting does serve a purpose in the economy, Mr. Christison says.
"Shorting enhances liquidity in a market and it gives important risk management tools to major market players, such as pension plans, institutions, banks, insurance companies, industrial and commodity companies and even governments," he explains. It can work as a hedge, reducing market risk, at times when markets go down persistently, as happened in the 2008 crash.
Cautions on shorting
Mr. Christison, of IFM, offers this advice on short selling:
- Only invest money you can afford to lose.
- Keep your eyes and mind open, don't make simple assumptions. For example, one might simply assume that as oil prices go really low, oil companies will stop producing. But these companies might keep producing to service debt and meet contract commitments, and their stocks might still rise as prices slump.
- Don't be greedy – set a target price for finishing your short transaction and do it.
- Watch for signs that your get-rich-quick idea for shorting isn't working – and get out fast. Don't stay in love with your short trade if it betrays you.
Even if you follow these rules, remember: For most of us, shorting is still a bad idea.