How to make money from falling share prices

With shares in Northern Rock plummenting, hedge funds have made a fortune from the falling price by 'shorting' their shares. So how did they do it and can you do the same?

So far the main losers from the turmoil that has engulfed Northern Rock are not its account holders, but its shareholders, who have seen the share price fall from a peak of £12 to just over £3. But one group of investors, mainly hedge funds, has made a fortune from the bank's plummeting stock price by "shorting" its shares. So how did they do it and can you do the same?

Selling shares you don't own

The classic short sale, typically used by investment bank trading desks and hedge funds, works like this. The short-seller borrows, say, 10,000 Barclays shares from a lender such as a pension fund. The pension fund will charge a fee for the loan (usually based on the number of shares borrowed and the length of the loan period). The short-seller then sells the borrowed shares at the current market price let's say it's 580p. If the price then falls to 530p, the borrower buys another 10,000 Barclays shares, then returns them to the original lender. The short-seller makes £5,000 profit (50p x 10,000 shares), minus the agreed interest charge.

This can backfire horribly if share prices rise. Having sold the borrowed shares for 580p, a hedge fund might have to buy back for, say, 630p, before they can be returned; a loss of £5,000, not including the interest charge on the loan. As, theoretically, prices can rise to infinity (but can only fall to zero), losses from shorting are potentially unlimited. But even if you are willing to live with the risks, UK regulations make this type of short-selling, based on borrowed stock, difficult for retail investors. However, there are several other ways you can make money from falling prices.

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Spread betting

Given the fallout from the US subprime lending crisis, you might reckon that banking stocks have further to fall. If so, you could pick a banking stock and place a spreadbet for just a few days, weeks or months. Let's say you are bearish about Barclays, and your broker is offering bid and offer prices of 578p and 582p. You could place a down bet at £5 a point (a point representing a one-pence movement in the Barclays share price) at the bid price of 578p. A few days later, with the share price struggling, the bid and offer prices are down to 552p and 556p. By closing your bet you make a profit of 22 points (578p-556p), or £110 at £5 per point. But remember, if prices move up rather than down you could easily lose a similar amount or more. So stick to a low deal size if you are new to spreadbetting this could be as low as 50p or £1 per point and use stop losses, often offered for nothing by bigger firms such as City Index, so that you cap your losses should a bet backfire. Lastly, while using spread­bets to short banking or retail stocks could be profitable as the UK consumer boom peters out, it's risky as individual shares can be volatile (particularly when the threat of Government intervention hangs over a sector, as Northern Rock has shown). A safer alternative is to place a down bet on an index such as the FTSE 250 or the S&P 500 if you believe, as does Alan Greenspan in this week's Daily Telegraph, that the UK and US economies are slowing.

Exchange-traded funds (ETFs)

If you are bearish on US financial stocks there is now a US-listed exchange traded fund called Ultrashort Financials Proshare (SKF), which offers "200% inverse leverage" to the Dow Jones US Financials Index. In other words, the share price of the ETF rises by twice the amount of any fall in the ProShare financials index. Such a fall could easily be triggered by poor third- and fourth-quarter results from the major US banks. As MoneyWeek regular Tim Price of Union Bancaire Prive told us recently, "It's one to buy if you really hate US banks, which I do." The main drawbacks are that the ETF is denominated in the US dollar; and the 200% inverse leverage works both ways: the ETF share price could fall rapidly if the underlying financial stocks stage a recovery.

Covered warrants

If you want to invest in sterling, cap your downside if things go wrong, but still profit from falling prices, then you should consider covered warrants. These basically give you the option to buy (a "call" warrant) or sell (a "put" warrant) a share at a specific price (the "strike price") on a specific date. For example, as a bearish investor on Barclays you could pay a one-off premium of £850 to buy 1,000 put warrants for, say, 85p each, with a strike price of 650p each, and an expiry of 21 December 2007. Your maximum loss is limited to the premium of £850 should the Barclays share price rise beyond 650p by 21 December. But if the share price falls to, say, 500p per share by then, you'd make £650. How? The gap of £1.50 between 500p and the strike of 650p on 1,000 warrants gives a profit of £1,500, from which you deduct the £850, which gives £650 overall, or a 76% return.

The price you pay (the "premium") is influenced by several factors. There's the gap between the strike price and the current price you pay more for a warrant that's already in the money'. Also, just like an insurance policy, the longer you plan to hold a warrant, the more you pay. Equally, the more volatile the share on which the warrant is based, the higher the overall premium because, if a sharp fall in the Barclays share price is expected, you could make a lot of money as the holder of a Barclays "put" warrant. Finally, "European-style" warrants can only be cashed on one date and therefore cost less than if you are offered the chance ("American style") to use the warrant on any date before it expires.

CFDs and spreadbetting are offered by IG Markets / IG Index; City Index; and CMC Markets.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.