Short selling is a practice with a bad name. In times of financial crisis, regulators and governments take aim at short sellers as pirates only out for themselves. But in reality short sellers face far greater risks and as a result practictioners tend to be some of the most financially savvy and literate investors in the market - often acting as 'policemen' against financial shenanigans. By learning some tricks to highlight good candidates for short selling the practice can possibly enhance your returns and lower your portfolio volatility.
What is a short sale?
Short selling is the practice of selling borrowed shares in order to buy them back at a cheaper price when the share price falls thus bagging a profit. Short sellers don't own the shares they sell, so they need to borrow them for a fee from a current shareholder.
The profit/loss equation for short sellers is very different to owning shares. When short selling your maximum gain is capped at 100% if the share price falls to zero, whereas the potential loss could be infinite as share prices can theoretically rise indefinitely.
Shares also need to be borrowed from owners before a sale can be made meaning that short sellers also face ongoing interest costs. These costs make it absolutely vital that short sellers only enter positions when the timing is perfect as it can be a very expensive business when it goes wrong.
How short selling can improve your returns
Ever since the dotcom bubble burst in 2000, equity investors have been subject to a dirty dozen years of volatile sideways markets. In this time there have been 2 great bear markets providing vicious swings to the downside and great opportunities to short sellers.
In sideways markets with deflating credit conditions the traditional philosophy of buy and hold is shortsighted and smart investors hedge their long portfolios with a smaller proportion of short sales. Strategies such as 130:30 which add a 30% leverage to a long only portfolio in order to short the market are becoming more popular amongst fund management community providing greater upside potential and downside protection.
The art of a smart short sale
While high P/E ratio stocks have been shown to underperform low P/E ratio stocks, in the long run high P/E stocks still have had **positive returns**. In other words shorting high valuation…
