Shorting For Dummies

With my lunchtime bolthole returning for the forseeable future, it felt rude of me to not pop out of the office and give a quick overview of how the average investor can short.

Of course, with all of the bad press around short selling in the last year - especially its supposed role in the credit crisis, one might reasonably ask why you would want to. One good reason is that a major market rise has now been underway for the past 5 weeks or so, and the apparent euphoria from some financials reporting better than expected results belies the wider economic downturn, and has the hallmarks of a house of cards built on sand.

Markets do typically reach the bottom 6-9mths before we emerge from each recession, so we ought to be there soon, but it is going to be an uneven ride that provides opportunity for profits both ways.

As every day of rises passes, so too does the potential for quick profits from shorting. Individual shorting is a process that the average investor cannot access easily - it requires access to the OTC markets, and additionally extreme caution when combined with leveraging instruments such as futures and derivatives.

In the same way as investing in gold and other commodities is now accessible to the wider market through exchange traded funds (ETF's), so the same principle has been applied for shorting through inverse ETF's. These essentially work by short selling a basket of stocks to mirror their underlying asset class or indices, and in doing so provide an inverse return. Through derivatives, versions even exist which provide a degree of leveraging - hence magnifying the ETF's rises or falls, with equivalent gain or loss for investors.

I recommend reading the Wikipedia article, as while it is simplistic, it provides a useful list of many inverse ETF's, as well as highlighting the higher fees required by an inverse ETF, which make this a strategy that should only be employed in the short-term (unlike conventional ETF's, which are more akin to tracker funds). Additionally this Trading Markets article gives further detail on how to use inverse ETF's, including for all-important hedging.

As with any investment, this is one to research before using and certainly requires caution - not least because the market direction will be upward over the coming years. Having said that, I have concluded that this particular market run is due a downward correction at some point soon, and so shorted the S&P 500 through ProShares Ultrashort yesterday.