Episode 10: Short Selling & Contracts for Difference

In this episode we are going to look at some more advanced strategies: Short Selling, and Trading Contracts for Difference.

Transcript: 

'Successful Trading' - Episode 10: Short Selling & Contracts for Difference

Presented by Jeff Bryant, HomeTrader.

Hello – and welcome to Episode 10 in our series on becoming a Successful Trader.     Up until now in this series, whatever I’ve talked about, has been in the context of shares, on what we call - the long side of the market. That’s the standard, and by far the most common approach to the stock market.   You buy some shares and if the price goes up, you make money. 

You might recall my reference in an earlier episode to the Prime CriteriaWhen we own shares, we want the price to go up. Indeed!  This is trading on, the long side of the market, or, ‘going long’, as we say.  When the market is going down, that's the 'short' side of the market. These are so-called because, as you may know, prices can take quite a  'long' time to go up, but can come down in quite a short' time. In this episode we are going to look at some more advanced strategies: Short Selling, and Trading Contracts for Difference.

We know the market can only go in 3 directions – up, down and sideways;and, that its predominant direction is up.   But of course, it doesn’t go up all the time. So, what will you do when it’s going south?If you trade only the long side, as the market drops, your exit strategies kick in and you get taken out of your positions.  In light of the global financial crisis, this would be a good thing!

But what then?  Well – nothing!  You simply wait for the market to resume its long-term uptrend. If however, you understand Short Selling, other opportunities will open up for you. Let me explain. Short selling allows you to make money when prices fall.   That’s right – price drops – you profit. 

Take this example: We sell to open 1000 XYZ’s at $5. 00, position size is $5000.  If the price subsequently falls to $4. 00, you buy,the cost is only $4000 - you make $1000. Price falls – you make money!The trick of course is that you sell first, then buy later – which raises the question: How do you sell shares you don’t own?     Simply, your broker will borrow on your behalf so you can sell.

It will likely be important, for those with self-managed super funds, to understand that at this point, a loan is established.   Within 6 months, you will be required to repay the loan.   To do this you would buy shares which are then used to offset the loan and the trade is concluded.  The beauty of being able to do this is that you are able to make money when the market is falling. It’s not about trying to pick winners in a bear market; you are actually profiting from falling prices. This has two great benefits
1. You can make money in bear markets, and
2.  You get smoother returns over the long haul.

Now, so far, I have been referring to short selling the underlying stock – using shares.   Perhaps a more efficient way of short selling is using Contract for Difference – or CFDs as they are known.  It’s certainly a more cost-effective way of short selling, as it can be done online with much lower commissions, and an interest rebate –  that’s right, they pay you interest!

Trading CFDs is the other advanced strategy I want to talk about in this session. The key feature of CFDs is that they allow us to use leverage.  Now, short selling as described above is also a leveraged form of trading. But with CFDs we can apply this leverage to both sides of the market – the long side where prices are rising and the short side where prices are falling.

 Since the art of trading CFDs, or any other derivative product, is really the art of managing leverage, or gearing as it’s also known – let’s now take a moment to look at it more closely. If we buy $10000 worth of shares, that is our exposure to the market.   The cost of this would be $10000. If that position moves in either direction by 10% we make or lose $1000.   Simple arithmetic. T

aking advantage of leverage means that we get the same amount of exposure, at a lower cost. We refer to those who make this possible as “providers” – because they provide us the opportunity. The way it works is that, for that exposure of $10,000, you don’t need to actually spend any money – you just need to make sure you maintain a certain minimum account balance.  Think of it as a deposit – it is known as the minimum margin requirement.   And further – there is no loan.

 In our example, let’s imagine the provider’s minimum requirement is 20%.    At 20% margin, that exposure of $10000 would require only $2000 cash in your account.  If that 10% move earlier was profit of $1000, and we only need $2000 cash, then, at that level, the return on our trade is not the 10%, but 50%!Our money was leveraged up from $2000 to $10000 – we leveraged 5 times.   The results of what we do are amplified by the amount we leverage. The more we leverage, the higher returns – gotta like that idea – but it works in both directions.   If that $1000 was a loss and we were using a margin of $2000 – we lose 50% - half our money!

The art of trading with leverage is to determine how much you can tolerate when things go against you. When you learn how to do this properly, your opportunities increase significantly. As always, if you’d like further information, you can visit our website at hometrader. com. au, and book in to one of our free 2-hour information seminars.