Editor’s note: This article was first published in October 2012, on 17 October 2012. The IBEX futures example (a margin of 7,000-10,000 euros, 10 euros per point) and the 1,880 euros you would have made today reflect market conditions at the time; margin requirements change. The margin trading terms describe the Spanish retail market around 2012.
As most of you already know, in stock market investing you can make money both when the market rises and when it falls. We can open long positions (bullish, betting that the price will go up) or short positions (bearish, betting that the price will go down). This means an investor who devotes time to the markets can ride the rises with long positions and, rather than simply selling when a share or index approaches a resistance level (one we think it won’t break through), can close the initial long position and open a short one.
We’re going to set out and explain how most of the vehicles or investment products used to go short work. Bear in mind that you can open short positions not only on shares but also on currencies, commodities and the indices themselves. The products used for this are CFDs, warrants, ETFs, futures and options. In my view, the most advisable are CFDs.
All these products have something in common: leverage. In other words, they are products with which we can invest more money than we have available in our account. They are credit operations, some with a mandatory expiry date and others with no expiry at all. There is also intraday trading, which we have already explained, although being obliged to close the trade the same day is not always advisable. Another thing these products have in common is the high risk of losses they can carry because of their high leverage, which is why they are not advisable for people without experience or without the discipline to cut a loss as soon as possible. Here are the pros and cons of each.
1. Investing with futures
Futures are contracts with which an investor can sell without having bought first, and with high leverage on indices and shares.
Pros: Gains and losses are settled daily. When the market closes, the amount of any gain is credited to your account and the amount of any loss is debited.
Cons: It is a very illiquid product; in Spain at least, trades rarely get matched. In addition, the contract has an expiry date which, win or lose, forces you to close the open position.
Example: Suppose you buy a futures contract betting that the IBEX will rise. To start with, you are required to put up a margin that is usually high (7,000–10,000 euros), an amount held in your account until you close the position. For every point the IBEX rises, you make 10 euros, so today alone you would have made 1,880 euros, which isn’t bad at all. Of course, had you bet on a fall, those same 1,880 euros would have been a loss.
For small investors there is the Mini-IBEX, which requires a much smaller margin and pays 1 euro per IBEX point instead of 10.
It is a product widely used to hedge a position. If you have a share portfolio you don’t want to part with but a bearish phase may be coming, you can take out a futures contract that bets against the market. If the market falls, you make money on the future even though your shares lose value; if the market ends up rising, you lose money on the future but make it on the shares. Think of it as a way to get through volatile periods, aiming not to lose in exchange for not winning.
Of course, if this strategy isn’t carried out properly, you may find your shares falling while the index rises, potentially doubling your losses on two different fronts.
Even so, in periods with a clear trend it is a good product, and it is also available for some individual shares, with the problem we have already mentioned: if index futures have little trading volume, seeing a trade matched on single-stock futures is practically a pipe dream.
2. Investing with options
Options are similar to futures. An option is a contract that gives the buyer the right to buy (call) or sell (put) an underlying asset (shares, indices, etc.) at a set price on a fixed date (expiry). In exchange, the buyer pays a premium to the seller, who is obliged to buy or sell if the buyer exercises the right. Options are priced according to the price of the underlying asset, volatility and the time left to expiry.
Although this investment product was originally designed to hedge a portfolio, over time investors began using it to speculate on falling markets. However, since futures exist, there is no reason to use options: they are similar and carry the same risk of losses, even though some say the risks are easier to control with this product.
3. Investing with CFDs
As we said, this is by far the most advisable of the products mentioned. Its main advantage over futures, options and warrants is that it has no expiry date. Another big advantage is liquidity, which is exactly the same as that of the underlying shares: if you invest in a heavily traded share, liquidity will be high, and if you invest in a thinly traded share, liquidity will be low.
With this product we can open long or short positions with high leverage. Since we are investing with leverage and no expiry date (the trade is being financed on credit), this product involves daily interest as well as a brokerage commission.
When you sign up for this product, the opening cost and the daily charge are usually set out very clearly.
The drawback is that not every bank offers this product on its trading platforms, something I imagine they will gradually introduce, so for now you usually have to turn to other kinds of platforms.
4. Margin trading
This is the oldest method, and it can only be used to invest in the stocks that make up the IBEX 35. It works exactly like intraday trading, except that the position can stay open for 3 months (as a general rule). You only need to have 20–25% of the total amount you are going to invest in your account.
With this method you can open both long and short positions without needing to own the shares when you decide to sell (go short). Standard commissions apply to purchases and sales.
One drawback is that, because of how this kind of trading works when going short (the shares are lent to you), you may sometimes have trouble getting hold of shares, since the broker might not have all the shares you want available, something that doesn’t happen with CFDs.
We are not going to explain how warrants and ETFs work: first, so as not to make the article too long, and second, because we believe that with CFDs, margin trading and futures available, the others are not particularly attractive, for various reasons.
Keep in mind that any of these products can cause you a loss larger than the money in your account, so it is absolutely essential to understand the risks before using them and to place stop-loss orders. Likewise, by choosing the right share and correctly calling the trend (up or down), leverage can deliver juicy returns.
A final thought
There is a saying in the markets that stocks take the stairs up and the elevator down, meaning that falls tend to be sharper than rises. That is what makes these products so attractive: a sharp drop in a share generates more profit in a single day (if we bet against it) than several days of gains (if we bet on a rise). We are speaking in general terms, of course; there are obviously exceptions.
Good investors take advantage of both market trends, and these are the instruments they tend to use. Once you know them, you understand why there is sometimes so much interest in bringing down a country or its currency.
Further reading
- Stock market mistakes and tips from market professionals
- Stock market curiosities: when is it most profitable to invest?
Featured image: Szilas, Public domain, via Wikimedia Commons.
