Financial Markets – Bears

Financial Markets Explained

Most investors are bulls. Investing is an act of optimism, so it doesn’t fit well with predictions of price falls. The natural reaction to the prospects of a bear market is to take your cash off the table and place it in the bank.

If you’re aiming to make money in a bear market by buying a select few shares that might go against the trend, is a very difficult game to play. Even contrarians feel it’s a feeble way to trade as the odds are stacked against you. There is another solution, however. For those who would like to put a wager on a fall, the thing to do is ‘go short’.

The business of going short is not as easy as the bull tack of going long. While contacting a broker and buying is easy, calling and selling shares that aren’t yours is not.

This isn’t the only dilemma. If you go long, you can potentially lose all your money, but if you go short, your potential loss is absolute, yet your potential gain is finite.

For instance, if you bought Garbage PLC at £1 and for some wondrous reason it went up to £11, your financial gain would be 1,000%. If the corporation collapses, then all you lose is £1 per share. Losing your pound would be upsetting but not life changing. However, if you went short and the company went bust, you would make £1 a share. That’s a pretty good return to be sure, but if it rose to £11 you would lose £10: a risk/return ratio of 10/1.

So, going long has a restricted downside and an unlimited upside whereas going short has the reverse. This is sufficient to put most people off.

Bears comfort themselves with the fact that nothing goes up infinitely, however being a director myself of a PLC that rose from 14p to 280p in a couple of weeks, I can understand those who prefer to put their lucre in the post office rather than use it to go short. Nevertheless, going short is about the only way to make money in a bear market. You can choose stocks you think are generally weak and that a bear market will lay low or merely short the indices like the FTSE 100 with a view to profit from the general trend.

How do you do it?

There are considerably few ways to go short, so a look at the basics is a good idea.

Shorting is selling what you don’t have, in the anticipation of buying it back cheaper later on. This is not as abnormal as it seems – farmers sell their crops short all the time. They sell their wheat even though they haven’t grown yet and deliver it when it’s grown.

For equities, this isn’t so easy as you can’t grow a share certificate and the buyer of your phantom stock might come visiting to get his certificate if you don’t produce it immediately. Shorting with no way of producing a share certificate is called a ‘naked short’. A dim view is taken of this in the UK and verboten in the US.

If a share not owned by you was sold and bought back before the broker required the certificate (that is within the T5, T10 or perhaps T20 accounting period) this would be a naked short. This is a very risky approach and strictly for those with more testosterone than IQ. Naked shorting is a precarious game and can prove embarrassing, complex and expensive, as well as being illegal in the US.

The ‘best’ way to go short is to firstly borrow the shares you want to short – another way that seems strange on the face of it. You loan the stock of someone who doesn’t mind lending it to you, sell it to somebody who wants to buy it and then you are legitimately short without any loose ends.

You owe the lender the stock you had loaned and therefore have minus shares, the person who purchased them from you has got his share certificates as per usual, and the lender gains cash security for the stock you borrowed, including an ongoing fee for lending you the shares. Everyone is happy.

You might wonder why on earth anyone would lend you their shares so you can go short. It’s simply because they think you are wrong and you have given him the cash security, so if you hotfoot it to South America without returning the stock, he is covered. He will then be making a profit from you by loaning his shares while you take a gamble on a fall in prices. The lender assumes the share price will be unaffected by increasing the shares available to be sold, and that it will all come out in the wash over the long term. Consequently, they make some extra money.

By and large, this is correct, but nevertheless the idea sits rather awkwardly with being a sensible investor. Generally speaking, you are lending shares you’ve invested in, with the belief they will rise, to someone who will profit from their fall, and then you are selling stock but it doesn’t exist back into the market in the hope that the price will tank.