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Personal Finance: Going short

Going short entails taking a view towards making money out of a declining market. It is somewhat a less common position to take and is sometimes difficult to understand.

One of the main reasons for this is that the markets are geared in the mainstream to be "up" or long plays. This is in essence a one-sided world where you might hear that the market had its best day in the last two months. It means it went up of course. Or maybe the market had its worst day this year. It means it went down. But why is "up" universally labeled as good, and “down” as bad!

Well the answer is that almost the entire population is goaded into buying stocks and so when stocks go up the value of their holdings goes up. Good for them. But not good if you haven't bought yet, it means you will have to pay more. If the market goes down it’s not necessarily bad. Maybe bad for those holding stocks and looking to sell, but certainly not bad if you are short hoping for prices to go down, or waiting to buy stocks at a cheaper price. A down day would be a good day for you.

Still below peaks

Finance Going ShortStill it is never reported as such. Down is always bad and that is that. It is the blind trust in faith that stocks will always rise indefinitely. Over the long term this is true. Look over two hundred or three hundred years and stocks will have risen. But there are plenty of exceptions. The Nikkei 225 stock market has had a big rally of late taking it from 8000 to 14000 in just the last six months. But let us not forget this index was at over 40,000 in the 80's. So for 30 years or so, more than a generation, the market has not gone up at all. It has in fact lost nearly two thirds of its value. Even here in Thailand the SET index posted 1800 or more points in 1997 and still has not reached that level, indeed it is considerably below it, even after 17 years. And whilst the Dow is hitting new highs they are not much higher than the index saw six or seven years ago, and they are looking top heavy already. This is why shorters are sometimes a disliked group, profiting from the misery of the mainstream. Yet there is nothing to stop anyone shorting a commodity or a stock market if they feel it is overvalued.

So let’s look at shorting a in a little more detail. If there is a stock or commodity that seems over-priced, and you don't own it, how can you take advantage of the high price and the expected drop? Well it’s the same principle when buying low and selling high a stock or commodity. Indeed it is exactly the same. You still buy low and sell high, but it is in reverse order, selling first. Still many people can't get their heads around the fact they have to sell something before they own it. The answer is simple. The trade entails, in an invisible way, borrowing the security, then selling it into the market at, what you hope, is a high price. You now have cash in hand for the commodity you have just sold. But you are also now net short. It means you are short of stock. The meaning is the same as the common phrase being short of cash. i.e. you need cash. In the case of shorting a security, you are short of that security, simply you are in need of the security to satisfy your lender.

A Golden Example

FinanceTo look at it another way let’s assume that your friend owns a 75 oz. gold bar worth three million baht. He agrees to lend it to you, for a small fee, and you can do whatever you like with it but he wants that gold bar back, or one that is absolutely identical. His idea is that gold prices won't go down and the lender fee will be handy extra cash. You on the other hand think gold is overpriced and will drop sharply very soon. You borrow the gold bar and you immediately sell it for the current market price of three million baht. 

You are now short of one 75 oz. gold bar. But you have the money. All you want to see is the price of gold dropping so you can use only some of the money to buy back the gold, and keep the rest. Let’s assume that two weeks later 75 oz. gold bars drop in price to 2.8 million baht. You have three million baht still in hand. Remember your friend just wants his gold bar back, nothing more, nothing less. You repurchase the same bar of gold for 2.8 million baht and return it to your friend. The 200,000 baht left over is yours to keep. You have effectively bought low and sold high, but you did it in reverse, selling high first and then buying back at a lower price. You made 200,000 baht on a price that went down!

Of course if the gold prices moved higher such that a 75oz. gold bar cost 3.2 million baht. then you would be facing a dilemma. Should you pay 3.2 million baht to give your friend back his gold bar, losing 200,000 of your own money in the process, (remember you only have three million from the original sale in hand), or do you wait for a reversal of gold prices so that they go back down like you originally hoped they would anyway? Gold could go up and up and up. Indeed waiting might mean unlimited losses, since theoretically gold could go ever higher. You decide to bite the bullet and buy the bar back for 3.2 million baht, funding it from the three million baht from the original sale, plus 200,000 baht from your own pocket. You will also have paid a small fee to your friend at the outset to borrow the gold also.

Your friend would have benefitted from the small fee only, since all he has back is his original gold bar, though of course it is worth 200,000 baht more than it was when he lent it to you, but it would have been anyway. You lost 200,000 baht on gold prices going higher, because you took the opposite view.

You can use this method to short stocks, indexes, currencies and all sorts of commodities. If prices are high then you can go short and benefit if the price drops. It means you don't necessarily have to miss out on price rises in any market, but you will need to see a corresponding drop. Note that the risk is theoretically unlimited, but with stops in place you can limit risks if you are disciplined.

In the current markets where many prices are at all time highs due to easy money courtesy of the U.S. Federal Reserve, there could be some very good shorting opportunities as the easy money starts to dry up. All indications point to this occurring relatively soon.