When it comes to share investing, we’re all familiar with the idea of going ‘long’. That is, buying shares in anticipation of a capital gain. And if we use a typical risk management strategy, we’ll use a stop-loss to help protect us on the downside.
Shorting shares — that is, selling shares you don’t own in anticipation of them falling, and buying them back at a lower price — is a common strategy among hedge funds. While shorting is available on some trading platforms, it’s much less common for private investors to go ‘short’ as it is to go ‘long’.
Perhaps that’s got a lot to do with the biases we have. One, in particular, is that shares go up over time. If you’d bought bank stocks a couple of decades ago, this bias would be confirmed by the share price action over that period.
Despite some decent setbacks along the way, the Big Four banks are all trading at share prices many multiples of where they were 20 years ago. For example, in 1995, Westpac [ASX:WBC] was trading around $5.00, and Commonwealth Bank [ASX:CBA] at just $9.00.
Fast forward to the present, and Westpac is trading at around $31; CBA at around $77. And that’s after the big selloff the banking sector has experienced over the last 12 months.
While these types of moves might confirm this kind of ‘long’ bias with shares over a long timeframe, there are plenty of times when companies do the opposite. Like, go out of business, or see their share price trade sideways forever.
There are also times, like earnings reports, where it’s just too hard to predict what the share price might do over a shorter timeframe, like the next two to three months, for example. We’ve all seen companies report good news, only for the share price to tank. And the opposite too: Despite disappointing results, the market has already factored in the news, and the share price goes for a run.
Traders with experience in the futures markets, such as commodities and bonds, and indices and FX, are well familiar with trading both directions of the market. For them, there is no difference between going long and short.
One particular strategy we toyed around with on the trading floor was the concept of trading both directions at the same time. For example, going long the share price index (SPI), and short at the same time.
But why on Earth would you do that?
Let’s use the SPI (the futures market of the ASX 200) for an example to find out why.
Say the index is trading at 5000, and you have no idea which direction it is going to take. For the first leg, you’d buy the index at 5000, using a stop-loss of 4900, for example. At the same time, you’d short the index at 5000, using a stop-loss on this trade at 5100 (again, for example).
While the index might fluctuate, eventually one of the stop-losses is going to be hit, leaving you with a solitary position. Now, this could work remarkably well if the market moves strongly in one direction. Say the market rallied to 5500, you’d be up 500 points on one trade, and stopped out for a 100 point loss on the other.
However, if the market traded broadly sideways, say in a range of 4800 to 5200, you would end up stopped out on both legs, leaving you sitting on a loss on both trades. So it’s a strategy that can work when the market begins to trend strongly, but will chew up money in a choppy market.
While this type of trade might be easy to apply in the commodities, index and FX markets, you can also apply it to share trading. You can do this by shorting shares against those you already own. That is short selling borrowed shares (through your broker); not selling your existing shares.
You could also short contracts-for-difference (CFDs) against your physical holding. Again, using the same strategy as our index example above, run a stop-loss on both your long and short positions until one of them is triggered, leaving you with an outright position.
However, if you’re familiar with options, there is also another strategy you can use. It’s called a ‘straddle’, and this is how it works.
Let’s say a stock is trading at $5.00, and you’re unsure which way the price is going to run. It has an earnings report due out in a few weeks, which could dramatically swing the share price either way.
To implement the straddle, you buy a call option (for a bullish move) with a $5.00 exercise price, while simultaneously buying a put option (for a bearish move), also at a $5.00 strike price.
The call option allows the buyer to lock in a $5.00 entry price, even if the share price moves much higher. And the put option allows the buyer to lock in a $5.00 sale price, even if the share price moves much lower.
While this strategy might sound like a no-brainer — you can benefit from a share price move in either direction — it can actually be quite tricky to implement. Because you’re paying two lots of premium, the share price needs to move a long way in either direction to make it profitable.
For example, if the options cost 30 cents each, the share price would have to move at least 60 cents in one direction to make a profit. Plus there’s brokerage for both option trades. To get some of the premium back, though, you can close out one of your option positions, once the share price starts to move.
The other issue is if the share price barely moves — you won’t make much on either option trade. You’ll end up getting some of your premium back if you close out the positions. However, the cost of brokerage will also chew up some of your funds.
Picking a direction for the overall market is always hard; especially so for individual shares. But with some of these strategies at your disposal, you can see how you might capture an emerging trend, irrespective of which direction the share price moves.
Editor, Total Income