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When we think about making money from our investments, most of us imagine investing in shares, bonds, property, commodities or other assets that we expect will do well in the future. We invest our money today, in the hope that the price of these assets will rise over time, increasing the value of our savings.
It’s also possible to make money when the price of an asset falls by short selling or ‘shorting’ it. You do this by entering into a contract to sell an asset that you view as overvalued, buying it back for less on a specific date. If you are right, you will make a profit.
However, the value of an asset can go up or down. So if you short a stock and the price then rises, the losses can be painful. This is why shorting has typically been the preserve of skilled professional investors and hedge fund managers. Expertise and experience are crucial.
Mark Swain, co-manager of Elite Rated Smith & Williamson Enterprise fund, explains: “Investors can take short positions on stocks, bonds, indices or commodities via a contract for difference (CFD). For example, you could enter into a CFD with another party because you expect a company’s shares to fall at a later date. If you are proved right, the other party will have to pay you the difference between the company’s opening and closing share price over the stated period. For example, if we shorted 100,000 Vodafone shares, at say £2 a share, and then the shares fell to £1.50, we would make a profit of £50,000. However, if the shares rose to £2.50, we would lose £50,000.”
Shorting allows investors to make money from falling prices or stock markets. It also provides an opportunity to take a view on a stock where they think earnings or growth expectations are out of kilter with reality.
Many professional investors combine long and short positions in their portfolios with the aim of lowering volatility and improving the chances of generating a positive return, regardless of market conditions. This means investors can, in theory, participate to a degree when markets rise – but also gain some protection if markets tumble.