How to Profit from a Downward Market
“Buy Low, Sell High”, this is the norm of a profitable investing activity.
Most investors earn money by buying stocks and taking a profit when the price rises. The most difficult part of this strategy is to identify which stocks to buy that are going to rise in value in the future. Because the higher the price will go up the higher would be your gain. This investment strategy though is only good if the market is going up. There are times when the sharemarket is going down. Are we still able to earn profit from a downward market? The answer is yes. The strategy is called “Short Selling”.
Some investors do precisely the opposite of buying stocks and taking a profit when the price rises. These investors deliberately identify stocks they think are about to fall. Then, they sell those stocks short. This means selling the stocks they don’t actually have!
The objective of short selling is to buy back the stock when the price falls, and in the future, buying the same stock at a much lower price than the price at which they sold!
This strategy can generate huge profits in a downward market. This is one of the most popular strategy used by hedge funds. Individual investors find this difficult to implement though because they normally need to be settled in a few days. However, keen individual investors can still proceed to invest by using the services of special firms that facilitate short selling. The way it goes is that the investor needs to borrow the stock they want to short sell from the facilitating company. The latter provide the required shares to be sold short.
However, you may incur unlimited loss from short selling though if your price expectation does not happen. For instance, if an investor short sell a stock for $100 expecting the price to fall, but they instead jumped to $110 and kept on rising, the loss will become unlimited!
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Wilson, I think this post would be easier for people to understand with some graphs showing payoffs over change in prices.
The problem with short selling is it is very susceptible to insider trading. If manager or directors know their company is not doing well they can easily profit from it by short selling or buying puts.
As well as this, in a market experiencing heavy losses, short selling can accelerate falls and lead to market collapses, as in 1929.
This is why ASIC has placed strong limits on short selling in Australia.
However, short selling is very important to efficient markets as it leads to more accurate pricing of stocks. To counter perceived risks, in New York, a short sell trade can only be made on an uptick. This means the share price must be moving upwards.
Short sells are quite controversial but they can be part very profitable, very effective investment strategy.
Don’t you agree Wilson?
Um yea I guess I agree next time I will show graphs for easy understanding.
Insider trading also happens even if the market is going up. It’s very unfair to other investors and very unethical!
Short selling can also be used in investing in distressed companies under restructuring. The best strategy is called long-short strategy where you simultaneously invest in their distressed bonds and sell short their stocks. Under this strategy you profit whatever the direction of stock price is. If stock price goes up, gain on investments in bonds is higher than the loss on the short sale. When stock price goes down, the gain on the short sale exceeds the loss on the distressed bonds investment. Clever strategy right?
Whatever!!
Wilson, i tried to grasp what you mean but still very unclear.
Are you saying that short selling means buying high and selling low instead of the normal buy low sell high? How can you profit from that?
Wilson means selling high and buying low (as opposed to buying low and selling high)
With short selling, you make the sale before you make the purchase. If prices fall in between these transactions, you can make a profit.
I think its all easy to say.. but no one knows when it is really low… Yes, the market may have drop 140 pts yesterday but is that really the lowest level? or is it the new highest level?.. there is always a chance to drop even more.. or maybe there is a reason y it drops even more… I believe that the directors are always the ones pushing the shares up and down whenever they like to their advantage to earn… i believe that someone is playing up the prices…
Thanks Rod for answering Myrna’s query. I think it’s clear now. Isn’t it Myrna?
To Michelle, I agree it’s hard to predict the market. You won’t really know how far the market could go down. That’s why a skill on forecasting is very important otherwise if your market outlook is mistake you may suffer significant losses from short selling.
Insider trading is very bad to the market and the sad fact is that they’re happening. It’s one of those causes of an inefficient market where not all market players have access to all information that affect the stock price.
.. Thanks Roderick for the clarification!
Now I understand! My work colleague mentioned this to me before and i didn’t understand because I was not interested! At least I know a bit now even if i’m just a bookkeeper!
hi Wilson, i actually read the whole article and understood it haha. I think that you can profit at short selling but it would be based on the level of skills and experience you have at playing the market. So i guess that if you don’t profit, it may have something to do with your lack of experience or skills!
Hi there, why are you depressed at the moment? he he
Yep i agree you’re absolutely right. Short selling requires an extraordinary skills and maybe luck as well.
I just have one question, is short-selling allowed in any market in the world? Because it’s just like selling what you don’t actually have, as you mentioned. It appears to be unethical. It’s like me, for example, selling Wilson’s car to a third party when I don’t actually own the car.
Yes short selling is allowed anywhere. It’s just regulated to a certain extent. Like what Roderick say above, you can only short sell a security in New York if it’s uptick, which means if price is going up. So there’s a limitation.
You can sell something that you don’t have by borrowing it from someone who has and owns it. That’s the way it works. Anticipating that when you return it in the future the value of that may have fallen already.
It’s only used for items that are actively traded like financial instruments (investments) and commodities (oil and metals). It won’t probably work for things like a car!
To elaborate on Wilson’s last point, I believe we can say it requires a highly liquid market to trade in. It also requires that the asset be fungible. (Try looking that one up in your dictionaries at home)
Apart from equity investments (shares), other examples of things that can be short sold include:
You wouldn’t like it if someone borrowed your car and gave you back a slightly different one, so you can’t short sell a car, as it’s not fungible. (although Wilson probably wouldn’t mind a similar but slightly different car just now).
[...] on buying such as consumer goods (e.g. food items and groceries) and utilities (e.g. oil and gas). Short selling of cyclical stocks (e.g. real estate, banking) is also a good investment [...]