Finance 101. Leveraging and short selling
Leveraging and short-selling are alternative investment strategies traditionally used by the sophisticated investor. This style of investing aims to helps to mitigate the downside when markets are volatile. It also boosts returns when markets are up.
However, as with any investment, there are risks and rewards. On the risk side, a highly volatile market can greatly amplify losses on leveraged trades. And when markets are up, short-selling strategies can increase losses.
So how does all of this play out? Let’s look under the hood to see how short-selling and leveraging might work in your own portfolio.
“What is leveraging?”
How does leveraging work? It’s about using money to make money.
Leveraging basically means borrowing money to invest it.
Let’s say the cost of borrowing is low and there are good investment opportunities. Then, it makes sense to leverage an investment. The investor enjoys the value of the investment’s gain (minus what it cost to borrow)!
Here’s an example just to illustrate. Mason sees an opportunity to make an investment in a beachside banana stand that he thinks will give an excellent 10 percent return. Unfortunately, most of his money is already tied up in other investments or paying for his mortgage, car, groceries, etc. But he doesn’t want to just miss out on what he sees as a sure thing (There are no sure things in investing of course, but this banana stand business sure looks solid).
Mason’s wallet is empty, but his credit is good! He notes that the Canadian interest rate is 3.25 percent. He borrows a big lump sum and invests it — and his prediction comes true! He garners an 10 percent return on his money, minus the 3.25 percent interest cost. At the end of the day, he’s got an 6.75 percent return. (Of course, had Mason’s business failed, he would have had to pay the entire loan back, plus interest… but in this case, that didn’t happen.)
The same basic idea applies for portfolio managers. When they see an opportunity, they may borrow to invest, taking a calculated risk in order to boost returns for clients.
“What is short-selling?”
With short-selling, an investor borrows a security (eg. a stock) from someone who holds that security. The investor sells that security in the market. The borrower will later return that security, earning a profit from these transactions.
This can be confusing even for longtime investors, so let me lay out this concept as simply as I can:
Mason thinks the price of apples will go down to $2 per apple. However, right now, they are selling at $3 per apple.
Seeing an opportunity, Mason borrows an apple from Neville. He promises to return it. He sells the apple he borrowed for $3 at the market. When the price of apples drops, he goes back to the market. He buys an apple for $2 and gives that to Neville, paying him back. But now, Mason has earned $1 from these transactions!
As you saw in the example, if the price of the security goes down before the short-seller gives it back, that’s a good thing. Generally, you want your investments to go up. But with short-selling, you’re betting that the security is going to go down in value! And if it does go down and you time your transactions right, that benefits the investor.
Risk vs. reward in short-selling
What goes up may sometimes go down. What if the security goes up in the meantime? In that case, the investor will see a loss.
In this example, Mason borrows the apple from Neville and sells it for $3, just like last time. But this time, instead of going down, the price of apples goes up to $5 per apple (because apple-eating bugs destroyed most of the harvest).
Uh oh. The deadline is here. Now it’s time for Mason to give back the apple to Neville! Mason has to buy an apple for $5, which is $2 more than he sold it for! He has no profit and actually has to pay out of his own pocket to cover the loss.
In theory, there is no upper-limit as to how high a stock can go (eg. Facebook shares are worth about $158 today. There’s no cap to stop them going up to $1,580, or even more, in the future). Depending on the timing, a fund that uses short-selling might have to buy back the security when it’s value is high, even higher than the original price plus any proceeds.
Investors and portfolio managers often use this strategy to boost returns. It’s good for an investor to understand the risks of investing, as well as the rewards.
With leveraging, an investor is borrowing, to use money to make money. With short-selling, an investor borrows a stock, sells it, waits for the share price goes down, buys it at the lower price, and gives the stock back to the original lender while pocketing a profit. Shorts-selling and leverage are just some of the more sophisticated strategies that investors can use to try to boost their return.