In focus

How to profit from falling share prices

Investors who sell ‘short’ believe the price of a stock will decrease in value. They hope that if they buy it at the right time, they can potentially profit from it. This is the opposite of having a ‘long’ position where investors hold the stock, wanting the price to increase in value over time.

While some investors short sell stocks for purely speculative reasons, others want to hedge (that is, protect) their downside risk if they have a long investment position.

We look at all there is to know about short selling to see if you can really profit from falling share prices.

How short selling works

An investor borrows a stock from a stockbroker or securities lender, which they sell before searching the open market to buy the same stock at a lower price. The intention is that, before they need to return the stock to the lender, its value will drop – allowing them to make a profit.

Market makers also use short selling to provide liquidity in response to unanticipated demand or to hedge the risk of an economic long position in the same or related securities. So if the price of a stock rises, short sellers who buy it at the higher price will incur a loss.

Few Australian stockbrokers provide short selling services for local retail investors. This is due to the additional paperwork, collateral requirements, pre-authorisation conditions per trade, higher fees and minimum trade size of $50,000.

Further, if the borrowed stock pays a dividend, the short seller is responsible for paying this to the person or the firm making the loan.

Identifying short selling opportunities

To identify short sale targets, investors can use a range of approaches. These might include fundamental analysis or technical analysis.

Fundamental analysis is where a company’s financial records are examined to help determine if its stock price is overvalued and may be poised for a fall. Typically, a company's earnings per share (EPS) and sales growth tend to move in the same direction as its share price. However, it is also best to look beyond the financial statements – as a company may be underperform for reasons that don’t immediately impact its financial statements.

Technical analysis is where patterns in a stock's price movement are scrutinised. This can help investors determine if the stock is approaching a tipping point towards a downtrend. One potential sign of a seller's market is a stock that's been falling through cycles of lower lows while trading at higher volumes. Another indicator is a stock that's rebounded to the upper range of its trading pattern but appears to be losing momentum.

The benefits of short selling

There are benefits to participating in a short selling investment strategy:

  • Hedging risks. Using short selling to offset the downside risks of other assets in a portfolio is a recognised strategy for experienced long-term investors. Hedging positions by short selling can reduce a portfolio’s overall risk exposure.
  • Alpha enhancing opportunity. Financial markets are volatile and sensitive to many external forces. Having the opportunity to take a position on both sides of the market can be more beneficial than only having access to buying opportunities.
  • A broader investment universe. Without having the ability to short sell stocks, profit opportunities would be limited to only stocks that are doing well. Short selling provides an opportunity to profit from markets that are declining overall, or stocks that aren’t faring well, even when the market is growing.

Having said this, there are risks to be aware of too. Short selling is a complex trading strategy and involves many variables. For example, there is higher exposure to losses if the asset’s price doesn’t behave as expected. So if an asset’s price increases, losses could potentially be unlimited.

And if this happens, a ‘short squeeze’ can occur. This is when short sellers all try to cover their positions at once, pushing the price of the stock up even further and magnifying losses.

Long short investing made easy with Schroders

The Schroder Australian Equity Long Short Fund allows you to access the advantages of short selling through a managed fund. Our portfolio management team has significant experience in long, short and market-neutral funds, with a background of working for one of Australia’s best-performing hedge funds.

The Schroder Australian Equity Long Short Fund uses existing processes and resources adopted by our flagship Schroders Australian Equity core strategy.  Our process includes a purpose-built rigorous data assessment system to assess the potential for company financial stress. This then prompts closer scrutiny for potential shorting, helping to reduce the risk around short selling.

Our investment team evaluates stocks in the Australian and New Zealand listed equity markets, allowing them to take short positions in those that are overvalued, as well as long positions in stocks that are underappreciated by the market.

Schroders has been managing the strategy since August 2020. While the monthly returns have seen some volatility, the cumulative return (after fees) since inception has outperformed the benchmarkThis outperformance is attributable to both long and short positions.

Learn more about investing in the Schroder Australian Equity Long Short Fund:

Schroder Australian Equity Long Short Fund – Institutions

Schroder Australian Equity Long Short Fund – Financial Advisers

Schroder Australian Equity Long Short Fund - Individuals

 

[1] At the time of writing (09 May 2022) the fund has returned 24.11% (after fees) since August 2020. The S&P/ASX 200 Accumulation Index returned 16.38% over the same period.

 

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