Make Money in a Bear Market

When prices go down, many investors bail out, but short selling can be lucrative if you know what you’re doing. Clem Chambers explains how to make money from shares that plummet Most investors are bulls. Speculation and investing are acts of optimism, so they don’t fit well with predictions of price falls and doom. Most people’s natural response to the prospects of a bear market is to take their money off the table and stick it in the building society.

Clearly, trying to make money in a bear market by buying a select few shares that might go against the trend, is a very difficult game to play. Even a contrarian can feel it’s a wack way to trade as the odds are stacked against you. There is another option, however. For those who want to bet on a fall, the thing to do is ‘go short’.

The task of going short is not as simple as the bull tack of going long. While ringing a broker and buying is easy, calling and selling shares you don’t own is not.

This is not the only problem. If you go long, you can potentially lose all your money, but if you go short, your potential loss is infinite, yet your potential gain is finite.

For example, if you bought Garbage PLC at £1 and for some wondrous reason it went up to £11, your profit would be 1,000%. Nice work if you can get it. If the company collapses, then all you lose is £1 per share. Losing your pound would be sad but not life changing. However, if you went short and the company went bust, you would make £1 a share. That’s a nice return to be sure, but if it went to £11 you would lose £10: a risk/return ratio of 10/1.

So, going long has a limited downside and an unlimited upside whereas going short has the reverse. This is enough to put most people off.

Bears console themselves with the fact that nothing goes up infinitely, but as a director myself of a PLC that went from 14p to 280p in a couple of weeks, I can see the point of those who prefer to put their lucre in the post office rather than use it to go short. Nonetheless, going short is about the only way to make money in a bear market. You can pick stocks you think are generally weak and that a bear market will lay low or simply short the indices like the FTSE 100 with a view to profit from the general trend.

How do you do it?

There are quite a few ways to go short, so a look at the basics is a good idea.

Shorting is selling what you don’t have, in the hope of buying it back cheaper later on. This is not as perverse as it seems – farmers sell their crops short all the time. They sell wheat they haven’t grown yet and deliver it when it’s grown.

For equities, this is a little bit trickier as you can’t grow a share certificate and the purchaser of your phantom stock might come visiting to get his certificate if you don’t come up with it pronto. Shorting with no way to deliver a share certificate is called a ‘naked short’. This is frowned upon in the UK and verboten in the US.

If you sold a share you didn’t own and bought it back before the broker required the certificate (that is within the T5, T10 or perhaps T20 accounting period) this would be a naked short. This is a very risky tactic and strictly for those with more testosterone than IQ. Naked shorting is a dangerous game and can prove embarrassing, complicated and expensive, as well as being illegal in the US.

The ‘correct’ way to go short is to first borrow the shares you want to short – another concept that seems strange on the face of it. You borrow the stock of someone who doesn’t mind lending it to you, sell it to someone who wants to buy it and then you are properly short without any loose ends.

You owe the lender the stock you borrowed and therefore have minus shares, the chap who bought from you has got his share certificates as per usual, and the lender has got cash security for the stock you borrowed, plus an ongoing fee for lending you the shares. Everyone is happy.

As an aside, you might wonder why the hell anyone would lend you their shares so you can go short. It’s simply because they think you are wrong and you have given him the cash security, so if you leg it to South America without returning the stock, he is covered. Meanwhile, he is earning money from you by lending you his shares while you take a punt on a fall in prices. The lender believes the share price will be unaffected by increasing the shares available to be sold, and that it will all come out in the wash over the long term. In the meantime, they make some extra money.

By and large, this is correct, but nonetheless the idea sits rather uncomfortably with being a sensible investor. In effect, you are lending shares you’ve invested in, with the hope they will rise, to someone who will profit from their fall, and is selling stock that doesn’t really exist into the market in the hope that the price will tank.