Spread betting is a simple and effective method of short-selling, ie speculating that the price of an asset you don't own is going to fall. You can short-sell a wide variety of instruments all from one single account, including stock indices, domestic and foreign shares, bonds, interest rates, commodities and foreign exchange.
To understand the mechanics of shorting, let's take a simplified example. Vodafone shares are trading at 150p. You think they are likely to fall to 140p in the near future. So you open a short spread bet. You do so by placing a 'sell' order, even though you don't already have an open long position. Vodafone then falls as you expected to 140p. You close your short position by placing a 'buy' order. Your profit is 150p-140p = 10p.
Let's look at a number of do's and don'ts when placing short spread bets.
You can theoretically suffer unlimited losses on short spread bets. When you own an asset or have a 'long' spread-betting position, the worst that can happen is that your holding falls to zero. But a price could potentially rise to infinity.
With so many bearish news announcements in the market each day, price swings and intraday movements in both commodities and stocks can be hard to predict successfully. And correctly picking entry points for shorting in a sideways market requires a different set of strategies to those used in an obviously rising or falling market.
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Preparation
Short bets placed on rising assets have a low probability of catching minor downswings in the market. Nevertheless, novice traders often look first at these situations when hunting for shorting opportunities. They frequently end up getting impaled on the charging bulls' horns.
Of course, there are always periods of profit-taking after strong upward moves. However, these tend to be fairly brief. Accordingly, they should be seen as higher-risk trades.
Look at AMEC in Chart 1 (below), with its retracements at A, B and C. In hindsight, these seem like good shorting opportunities. But you'd have needed excellent timing. That's not always easy.
The profit probability of this set-up is also very low. Chart 1 shows a clear uptrend interspersed with sell-offs occurring at A, B and C of 15, 3 and 3 per cent, respectively. The ensuing rallies took the price up 13.3, 12.9 and 11.5 per cent, respectively.
Aside from the difficulties involved in timing, the risk-reward ratios are problematic here. A risk-reward ratio describes how much you stand to lose if you’re wrong compared with the gains if you're right.
For point A, 13 per cent risk compares with a 15 per cent reward, giving a ratio of 0.86:1. For B, it's 4:1, the same as for C. Risking four times as much as we stand to gain is clearly not an acceptable proposition. Trying to capitalise on minor moves while missing out on major ones will require more time, research and losses to be incurred.
Chart1
If you do attempt to trade these big profit-taking swings, make sure you are psychologically prepared to hang on for the big winner when the market changes from bullish to bearish and that you do not take profits too early. Otherwise, your account will be eroded by multiple losses encountered in the search for really big winners.
Deciding when to make an exit
Traditionally, most institutional money managers and City investment funds have been limited to holding long positions only, ie buying shares at a lower price with the intention of selling them at a higher price for a profit. This gives private investors an edge over these large investment institutions, which are unable to short shares. You can take advantage of this through spread betting.
Because of the long-only positions that fund managers hold, they are forced to exit shares as the price falls when they hit stop-loss levels.
This means that selling can continue long after the news event that causes prices to move lower. In addition, fund managers are prone to drop non-performing holdings in search of other assets that will perform.
A very different market mindset is required when spread betting in bullish and bearish markets. Here are two important points that should help you to preserve your capital when betting by avoiding inappropriate moments to place your bets.
Look at Persimmon in Chart 2 (below). First, look at the periods of consolidation before the bull market turns to a bear market at points A and B.
Points A and B show a classic case of redistribution, where long-term investors will be selling to take profits and speculators enter into the market at highs looking for further gains. In this situation, a number of short players in the market are exiting at the same time. For a longer-term spread bet, these are great entry points to place your bets if you can identify them.
Chart 2
Short bets on shares in bearish markets ought to be profitable very soon after they are placed. The down movements will often be long and extended and any rallies are met with resistance after short periods in time. Generally, speaking share prices tend to fall much faster than when they rise.
When the down-moves happen faster than the moves higher it's a sign that the market is accelerating to the downside. The reason this happens can usually be explained by panic selling by investors.
In chart 2 (above), we can see that the rallies to prior levels in July, September and March 2008 are met with immediate resistance. This repeats as a cycle.
The next important observation is the 'short squeeze' phenomenon at point C. This is a term used in the markets to describe a violent move upwards after a number of bearish days or weeks. Normally there is some form of news announcement about the company and the short players scramble to buy back the position on the good news. This is exacerbated by new long players joining in the rally. Volume levels will frequently increase at this point.
Markets swings tend to last longer and go further than normal rational reasoning would suggest they should. And when analysing the price behaviour to predict future moves, investors often forget that the market does not go up in a straight line. This is true in any time frame.
