It’s been causing problems for Tesla. It made George Soros’ name as “the man who broke the Bank of England”. There was even a major Hollywood film about it released a few years back. If you’re still lost, we’re talking about short selling: the art of profiting from falling prices, or even a major crash.
Financial analytics firm, S3 Partners, monitors so-called “short selling” in financial markets and recently announced that the value of corresponding positions on the Tesla share rose by 28% last month to almost $11 billion (€9 billion). According to experts, no other US company has been bet against as heavily as Tesla so consistently over the past two years. But we’re still yet to see a big crash at Tesla.
The Black Wednesday crisis made George Soros his fortune
Things weren’t quite the same for George Soros. He pocketed a $1 billion profit after his short sale of $10 billion worth of Pound sterling in 1992. At the time, he was gambling heavily against the British pound because, like other major investors, he was convinced it was overvalued.
Soros speculated at the time that the Bank of England would either have to devalue the currency or withdraw from the ERM entirely. Neither was an option for the central bank so it pushed interest rates from 10% to 12% instead, to make the pound more attractive. At the same time, the monetary authorities were holding out on the prospect of a further increase to 15%.
But the pound kept plummeting. The Bank of England pulled out of the ERM and reduced its interest rates back to 10%. In the weeks that followed, the currency lost 15% against the German mark and 25% against the US dollar, which is a great deal in foreign exchange trading. George Soros walked away with a tidy billion-dollar profit.
Short sellers can benefit from falling share prices
And then there’s the “The Big Short”, the film that tells the story of the hedge fund manager who recognised a bubble emerging in the US housing sector. More and more loans were being given out without collateral so he persuaded large investment firms to sell him credit default swaps against subprime deals he saw as vulnerable. In practice, if the underlying loan defaults, the owner of the shares puts these products in their fund and makes a fortune.
While the example from “The Big Short” is somewhat more complex, short positions — as in Tesla’s case — are now easy for anyone to follow. However, this does not mean they work for everyone. If you bet on falling prices, you place a bet and risk losing all the money you have invested.
In practice, you sell shares you don’t own. This is why it’s also referred to as short selling. The shares you sell, you borrow from a bank. The logic behind it is simple: you hope the price will fall and that the share can later be bought back more cheaply in order to return it to the bank, allowing you to make a profit from the difference between the sale price and the purchase price. There are now various products for these short positions, which are called warrants, certificates or CFDs, depending on their structure.
While short products offer great opportunities in a crash, they’re risky
Depending on the product, you may still be able to alter your bet. “Certain financial products move disproportionately to the underlying asset,” Comdirec market expert Andres Lipkow told Business Insider Deutschland. To illustrate, if you suspect the DAX is headed for a major crash, you can buy a short certificate. You are free to choose the leverage, so let’s take 10 as an example. If the DAX falls by 1%, your certificate rises by 10%. A crash with more violent price movements quickly brings a big profit.
The catch? If the DAX rises by 1% your certificate also loses 10%. So, while you have a greater chance of winning, you also have a higher risk of losing. Moreover, these products have a so-called “knock-out threshold”. If the DAX rises above this threshold, the share becomes worthless and you lose the entire stake.
So bascially, if you bet on falling prices, you’re placing a bet; you’re not making an investment for retirement plans. The prices of corresponding products move very quickly and so they can quickly lead to tremendous losses or, in the case of Soros, high profits. “However, as a private investor you should always be aware of the risk of total loss,” says Lipkow.
Betting on falling prices is only for experienced investors
“Only those who have already gained initial experience in the stock exchange and who have the time to keep an eye on their position, in order to make a speedy exit before the loss becomes too substantial, should invest in such products,” advises expert Lipkow. “It’s also important for a private investor to use only small amounts in such bets.”
But there is another application for this other than betting: You can “insure” your portfolio with short positions against major price losses. Anyone who has already made money with an investment on the stock exchange but is worried about price losses and doesn’t want to sell his positions can hedge his portfolio with short positions.
“If you put a short product in your portfolio with a small leverage for a small investment, investors are betting on falling prices. It follows that they stand to gain if the index falls according to original predictions. However, if prices do not fall, the company’s own shares will continue to rise and investors must regard the capital invested in hedging as an insurance premium.” Lipkow said.
There hasn’t been a big crash for a long time
Short ETFs, which are more transparent and easier to understand than certificates, could be a suitable means of hedging. They reflect the development of an entire index, such as the DAX. They allow you to protect or profit when markets shift and fall.
So, depending on their use, short positions can be a wild gamble or tactical means of hedging a portfolio. But short selling is not a long-term investment; there is risk of considerable loss. Though many experts have been expecting one for a while, there hasn’t been a substantial crash on the markets for a long time. So even if success stories like those of George Soros sound tempting, remember that many short sellers have already been caught on the wrong foot.