Three ways to reduce short selling risk

published 18 May 2012

With the euro crisis back in the headlines, there are plenty of targets for short sellers investors who like to bet on prices falling rather than rising. Over the last few days, as Greece has threatened to leave the euro and the scale of Spanish debt woes has become ever more apparent, it hasn't just been the euro that's fallen. Major indices such as the CAC (Paris), Dax (Frankfurt) and our own FTSE have also taken a beating. However before jumping in and joining the fray, be aware that shorting is risky and can backfire badly. Here's why and how to limit the damage.

Short sellers target things - currencies, shares, commodities, bonds, etc - that are overvalued. So they open sell trades initially, wait for the asset in question to drop and then close their positions with a buy trade. For example, as a spread better, if you think the FTSE 100 will drop from 5,400 points, you sell it and then hope to buy it back at 5,300. Your profit is the 100-point drop times the amount you bet per point.

But markets go up more often than they go down, so a short seller needs to be confident they are right. And, in theory at least, an index can rise to infinity, meaning if a short bet backfires it can do so very expensively. So here are three ways to make sure you don't get caught out.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Keep your bet size low

Through a broker such as FinSpreads, for example, you can bet as little as 10p per point for the first couple of months. Sure in the example above that limits your profit to just £10 (100 points x 10p) but it also means you can practise without losing your shirt.

Use stop losses

These get you out of a losing trade at a predetermined price. So, for example, a stop loss in the FTSE example above would be a buy order at, say, 5,450 points. Should the market rise rather than fall, your loss is limited to 50 points times your bet size.

Don't be duped into betting too soon

Sure in these volatile markets there are lots of opportunities for spread betters in currencies and indices. But do your homework first get good at reading charts and spotting resistance levels for example before you trade. Better to miss out on a few easy wins as a novice while you learn the ropes than become someone else's soft target.

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.