Shares of Domino's Pizza plummeted 19 per cent on Tuesday after the former market darling served up a lower-than-expected annual profit and warned that the extraordinary pace of growth of the past few years would slow.
It was a painful day for the pizza company's shareholders. But not so for investors, of whom there are many, who were holding short positions in the stock.
Figures from the Australian Securities and Investments Commission show that 11.3 per cent of Domino's shares have been shorted. In other words, 11.3 per cent of the shares have been sold by investors who do not own them in the hope that the price will fall. That puts Domino's in the top 15 most shorted stocks on the ASX in relative terms, alongside other household names such as retailers Myer and JB HiFi.
The reasons for taking short positions are varied. In the case of Domino's, many of the short sellers argue it is a solid, well-run business but say the shares are expensive. In some instances short sellers believe a business is in trouble or faces serious headwinds. In still other cases, investors take short positions to protect their portfolio from a market fall – in other words as a hedge.
So can individual investors get in on the act and take bets against share prices – individually or against the market as a whole – they consider too high?
The answer is yes and they are doing so more often.
"The efficiencies of online platforms have boosted this kind of activity. People are starting to use more of the tools available," says Michael McCarthy of CMC Markets, an online broker.
Tom Veidners, head of equity market surveillance at ASIC, says that on the upside shorting strategies can help investors make a profit "if they have a view that the market or individual stocks will fall or want to protect the value of their portfolio". But, he warns, they are not without risk.
"With any speculative product, the return is commensurate with the risk," Veidners says.
One of the best ways to enhance the probability of success is to follow the market trend. "You always want to be trading in the direction of the dominant trend where possible," says one expert.
Arguably investors want to have a reasonably short timeframe in mind, given that over time markets generally rise.
"Shorting the market over the long term tends to be a bad idea. In certain years and months it can be a good strategy, but then you are getting into market timing," says Tim Murphy, Morningstar director of manager research.
McCarthy concedes that shorting techniques tend to be used by more sophisticated individual investors.
"Generally speaking it is high net worth individuals and self-managed superannuation funds who [are using shorting techniques]," he says. The portfolio size of CMC clients who use short selling strategies tends to be between $250,000 and $2 million.
But, rather than short the stock physically, as professional investors do in the likes of Domino's, for individual investors there are cheaper, more convenient strategies.
Shorting physical stock
Shorting physical stock has its drawbacks.
One obstacle is the requirement that investors borrow the stock in order to sell it. So-called naked short selling, where investors do not borrow the stock, is for the most part illegal. Borrowing stock can be arranged through large brokers. Other brokers, such as CMC Markets, arrange stock borrowing through margin lending partners.
Borrowing stock comes at a cost. McCarthy estimates that the net cost of borrowing the stock could be between 1.5 per cent and 2 per cent, even though the investor has raised cash from the share sale and has money on deposit.
If the stock has been borrowed through a margin lender, a margin will need to be put down to protect the lender against losses. In the case of margin lender Leveraged Equities, the safety margin is 15 per cent.
Julia Lee, equity strategist at online broker Bell Direct, points out that the cost of holding the short position and the habit of share prices to rise inexplicably makes shorting less viable as a long-term strategy. "There is a time constraint because of the margining and borrowing costs involved. You can have a correct point of view but still not make money because of the timeframe," Lee says.
Another obstacle to shorting stocks is that the downside is limitless. If investors buy a share, the biggest potential loss is the amount paid for that share. If they take a short position, there is no limit as to how far the share price can rise, unless a stop-loss order is put over the transaction.
Added to these inconveniences is that most of the online brokers, including CommSec, don't allow physical short selling.
Contracts for difference
Contracts for difference (CFDs) and options are more common strategies that allow investors to take a bet that the price of a share, or a basket of shares, will fall.
A CFD is a tradeable instrument that mirrors the movements of the underlying asset. It allows for profits or losses to be realised when the underlying asset moves, but the actual underlying asset is never owned. The other key is that the investor pays a fraction of the total value of the contract. Given this leverage, gains – and losses – are magnified, whether a long or short position is taken.
Says Murphy: "You have to understand how leverage works."
McCarthy says that although CFDs on individual shares have been declining in popularity, they are becoming an increasingly popular method of betting against stocks, particularly baskets of stocks.
In order for the transaction to work, investors need to borrow the stock, typically through their broker. It can be hard to borrow stocks in less liquid companies, creating natural limits over which companies' CFDs can be sold short. CMC says that in broad terms it can borrow stock on any of the top 300 stocks listed on the ASX.
Here is how a trade could work.
BHP shares are trading at $26.00. An investor, worried about the imminent collapse in the iron ore and crude oil prices, wishes to take a bet on the share price falling.
The investor sells 800 share CFDs at market, entering into an agreement with a broker to settle, in cash, the difference between the opening price of $26.00 and future closing price of BHP, when they buy the position back.
BHP is a top tier company and the broker asks for 5 per cent of the face value of the stock to sell the shares, so the margin, or deposit, is $1040. This means the position is 20 times leveraged. Brokers would require a greater margin, say of between 5 per cent and 15 per cent for less liquid stocks, reducing the amount of leverage.
Unsurprisingly, there are charges involved.
Broker IG says it would charge a commission of $20.80, or 0.1 per cent of face value. A second commission is payable to close the trade.
Let's say the BHP share price falls to $22 and the investor chooses to close the trade. IG's commission to buy the stock back would be $17.60, or 0.1 per cent of face value. The total commission for the trade is therefore $38.40.
On top of the commission, there are funding and short selling charges.
The daily funding charge is 2.5 per cent below the one-month bank bill rate, currently 1.645 per cent, so in this case it would be 48c a day.
The short selling charge is 1 per cent of the total face value on the day, and is applied at a 1 per cent annualised rate. Again, this is payable daily.
As a result, says IG's Chris Weston: "[The] commission costs $38.40, [the] total funding and short sale costs will depend on the closing price each day, but would be around $2.50 each a day." It's a small holding cost, adds Weston.
In addition, notes McCarthy, the investor will need to reimburse the stock lender for the dividend, potentially plus franking, if the CFD is held over the ex-dividend date. The dividend payment, however, might be offset by a fall in the share price that typically follows dividend payments.
As with physical short selling, the downside can be unlimited if the shares rise, so brokers often recommend putting stop orders in place.
Exchange traded options
Another way to bet against a fall in share prices is to buy a put option, which is a contract giving the holder the right, but not the obligation, to sell a specified amount of underlying stock at a specified price within a specified time.
If the share price rises, the maximum loss is the premium paid for the contract.
If an investor owns a put option on BHP, they have the right to sell BHP shares at any time until the put option expires. The maximum possible profit is obtained if the stock declines all the way to zero. The profit made is equal to the strike price (say $26 in the case of BHP) less the premium paid for the contract, although charges need to be taken into account. The maximum potential risk is losing the entire premium paid to purchase the option if the stock is at or above the strike price at expiration.
The size of the premium will depend on the amount of time until the option's expiry and how close the underlying price is in relation to the option strike price.
All other things being equal, the longer the time to expiration, the more value the option will have and the more expensive it will be.CommSec, among others, offers trading in ASX-listed exchange traded options and company options, and also offers the ability to trade US options.
There are execution fees and ASX clear fees involved.
