Bear Markets and Short Selling

Bear markets have always been a fact of life for investors. Depending on how you count them, there have been about 4 or 5 prolonged periods of pessimism in the stock markets since 1900, of which the last started in 2000 and is still ongoing. These so-called ‘secular bear markets’ may contain some strong rallies, such as the one seen in 2009 and 2010. However, within a bear market, stock market indices will stop of previous highs and it won’t be long before they being to fall again, as happened during the second half of 2011.

One way to ride out a bear market is to adopt a more tactical approach to trading, playing the swings within the markets. If you’re willing to be tactical you could try to sell at the top and buy back at the bottom, holding cash for periods in between. The idea sound simple but in reality this strategy requires skills and experience. It is also important to remember that what looks cheap can get a lot cheaper.

Remember though, for every buyer prepared to buy a share, confident that it will rise in value, there is a seller who has lost confidence in that same share and believes it will be worth less tomorrow.

A good way to avoid losses is to buy good assets when the wider market is depressed. Looking at the crash of of 1987 and bear markets of 1991-93, 2000-03 and 2007-09 show how equities can reach very low levels and become sharply oversold. As soon as market sentiment improves, these stock are likely to bounce back sharply. The trick here being to spot those opportunities and buy and hold those shares in the confidence that the company’s profits and dividends in the long term will ultimately reveal its true worth.

Buying is the less onerous of the two decisions. Before you select a share you must do all your research: look at the website, the graphs, the financial facts, gather as much expert opinion and knowledge as you can, add a drop of gut instinct and take the plunge.

When to sell? Take the Slater mantra: Don’t be greedy. Easy to say, difficult to do. One of my friends has an inviolable rule: when he buys a share he makes a note of what he thinks would be a reasonable profit and puts a time limit on it. For example, if within 6 months the share rises 25% from the purchase price, he sells. But never look back.

Short Selling

Short selling is a strategy that spread traders can utilise to make material gains from falling prices. It is about selling a share without owning the underlying equity and buying it back at a lower price later in time. While institutions normally borrow shares so as to sell them short, retail traders can take short positions using internet trading platforms which permit spread betting or CFDs, effectively allowing you to take bets on a share or index falling in value.

Spread traders have to make a deposit on the stock which may be anything from 10% for FTSE 100 companies to 30% or more for FTSE 250 companies. However, individuals should be aware that they are still liable for the full market value of those shares and in the case of short positions, this liability is potentially unlimited.

My short positions are volatility based, so I “risk” 1.5% of my overall portfolio per bet, no more than about 6-8% overall (so 4-6 bets at most at any time), so reward is directly related to volatility, which I use ATR as a measure, multiplied by 2.5 to 3 times for a stop, for my 1.5% risk.

If however, as I would imagine, a lot of folks just “punt” without thinking about the amounts they are risking, especially if they are using a spread bet account (unlike a cfd account) they could quite easily over leverage, and wouldn’t realise it, as they think “its only £X/point, and it can’t move more than 20% against me, cos that is what I’m willing to sell at when it goes wrong” until the spread betting/CFD provider asks them to cough up the 30/50/100% margin even though it is suspended, short, and in profit.

I think quite a few on either side of this are going to get caught again by over leverage.

Needless to say I will be sleeping soundly every night until this is resolved.

As a side IG informed me that if I couldn’t meet the margin requirement, they would close any other open positions to cover the margin requirement without my say. If after that it still wasn’t covered then they would be chasing up for the extra monies to cover any margin.

I like to think in terms of total exposure not £/point.

So if I want to short £2k of shares and they are trading at 200p then that’s £10/pont.

Given that guaranteed stops are not always available and prevalence of spikes up in even the worst of companies that take out guaranteed stops I prefer to keep my total exposure to any one company low.

Of course when you get a likelihood of a total wipeout like we have in AFR I wish I had been braver but for long term results more small short positions beats 1 or 2 big bets. But small positions on stable markets is best, preferably distributed across short and long and not too concentrated in one sector. AFR is slightly different as one is betting against the herd. Of course as the herd move share prices irrationally one needs a very large available margin.

I also sometimes utilize limits, as sometimes shares move violently for a short period before returning to where they started.