Nearly every investor, and certainly every trader, has heard of selling short. For those who might want to refresh what they already know – or as background for those who aren’t familiar with the practice – selling short is when you sell a security you don’t own, with the stipulation that you will purchase the security at a later date. This commitment, to buy a security, stock, bond, or some other financial instrument at a future date, would hopefully occur when the price is lower. This is the opposite of what most investors or traders normally do, which is to buy a security at a given price with a belief or hope that the price will rise.
Here is an obvious example of how short selling works. You sell short a stock which has a current share price of $25. Then, if the stock price falls (as you anticipated it would), you buy it back at perhaps $20 a share. This, of course, represents the profit aspect of short selling, but – as in all investing and trading – there is risk. If you sell the stock at $25 a share, but it rises instead of falling (to $30 a share, for example), you will have to buy the stock at $30 after selling it at $20, so you have a loss. Why then would you consider using this strategy if it can lead to losses?
Ordinary investing involves buying a security (or going “long”) as opposed to selling the security (or going “short”). Selling short is a seemingly simple strategy often practiced by a number of investors, traders, and professional institutions in very sophisticated ways. This sell high, buy lower strategy is often employed when a trader, investor, or institution feels a stock (or a group of stocks, perhaps in a market sector) is greatly overvalued and due to come down in price. In other instances, the trader or investor will employ the strategy as portfolio insurance, when he has accumulated a large number (or dollar amount) of long positions in securities and wishes to protect himself against a possible downturn. It is ideally a method of lessening risk. Hedge funds, as their name suggests, do this routinely. The use of futures contracts and put options by individual investors or traders are other variations of the more straightforward short selling.
So what if this tactic interests you but you don’t consider yourself a very sophisticated investor? Can you use it? While it is best to use only investing or trading strategies you’re comfortable with and understand fully, once you have a basic understanding of short selling principles there are some relatively simple ways to utilize them. Again, when in doubt, never force yourself to undertake an investment strategy that you are unsure of. There is never any substitute for thorough knowledge and understanding.
That said, while you can short individual stocks or other securities, you can also use this strategy for market sectors. Suppose, for example, that you have come to the conclusion, through your market research, that a given average – the Dow, for example – is overvalued. Rather than short one or several stocks, you can short the entire Dow through what are called Exchange Traded Funds. These are mutual funds – aggregates of securities the same as other ordinary mutual funds – yet they trade like stocks. Instead of placing a large dollar amount in a mutual fund, you can buy exchange traded funds on a convenient share-by-share basis, which will do the short selling for you. The fund will reflect successful short selling by increasing its overall share price. This is all less confusing and counter-intuitive than it seems to inexperienced investors. Think of it as correctly selecting the direction of the share price of all the underlying stocks in the fund and being rewarded when you have made the correct selection.
Pro Shares is one group of exchange traded funds. The Pro Shares Short the Dow Fund (AMEX: DOG) does just what the name suggests; it attempts to short the Dow Jones stocks so that when the Dow goes up, the Short the Dow shares will fall, but when the Dow falls, the Short the Dow fund will rise. It simply trades in the inverse direction of the Dow. For example, if an investor is looking for the Dow to fall and buys shares of the ETF Short the Dow, when the Dow falls the value of the Short the Dow shares will increase, and the investor will make a profit. Of course, like all investments, there are no guarantees. The risk in shorting the Dow is that it will continue to rise and your shares in the ETF will be worth less. Again, knowledge and understanding are keys to successful investing.
Pro Shares Short the Dow have traded from 55.73-70.00 in the last year, and have recently been trading in the $64 a share range. Pro Shares has 58 exchange traded funds, many of which follow this investment pattern, offering opportunities to do short selling on everything from the Nasdaq to major commodities (and, of course, the Dow). It provides another opportunity for investors to make their portfolios more versatile and expand the scope of their investing horizons.
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