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Trading: the long and the short of it

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If you can keep your head while all around you are losing theirs, you’d probably make a good investor.

Times of turbulence on stock markets can be times of opportunity for the savvy investor. Picture the scene last week. City traders losing X billion pounds a day and having to cancel the order for that third gold-plated Porsche. Pension fund managers taking one look at their huge losses and… shrugging because it’s not their money. Uninformed media sources proclaiming the end of the world. Meanwhile, you could have been quietly sitting at your computer, raking in the cash.

Most people are aware that to be successful at investing you should buy low and sell high. What fewer people know is that you don’t have to do it in that order.

Buying low and selling high means that you are ‘long’ a particular entity. For example, if you buy shares in Skullcrusher’s Friendly Bailiff Debt Grabbers Plc at a price of 10p, in the expectation that they’ll reach 50p on the back of increasing debt defaults, you are long that trade.

But you could also sell high and buy low. If you think Skullcrusher doesn’t have much of a future because there’s no money left to collect, you could short the trade; borrowing the shares, selling them at 10p and hoping to buy them back at 2p, for example. In this case you would be short Skullcrusher Plc.

Not all share trading companies allow this, but going short means that you borrow something you don’t own, sell it and then buy it back later at a (hopefully) lower price, returning it to the person you borrowed it from. It simply means that the lower the price goes, the more money you can make.

You usually don’t have to worry about the details of how a long or short trade actually works; who lends you the shares, what interest you pay on them, etc. Most trading companies, especially those with an established online presence, make it very simple: click on the item you want to trade and you’ll be presented with two boxes: one to buy (long), one to sell (short).

The prices in the two boxes will be different: the buy price will be lower than the sell price. The difference between the two is called the bid/offer spread or bid/ask spread, and is how the trading companies make their money (the exception here is companies who charge you a fixed fee per trade). It means that, regardless of whether you’re long or short, the price has to move some distance in your favour before you recoup your initial trading fee. After that all profits (or losses) are yours.

So, going back to last week, if you were expecting a particular company’s share price to plummet, you could have shorted it and then made money all the way down. You would have to have had your wits about you to decide exactly when to open the trade and when to close it, but it could have made you a tidy profit.

However, what if you didn’t know which shares would go down (not all of them plummeted; some stagnated and a couple even rose), but were sure that the FTSE as a whole would drop? Now we come to an increasingly popular trading tool; the spread-bet.

Online spread-betting companies are gaining favour for several reasons. First, because any profits you make are tax-free: this is classed as gambling, even though you may be trading exactly the same shares as you would through a conventional tax-paying share trading account. One has to wonder how long it’ll be before Alistair Darling plugs this little hole, but for now, your winnings are entirely yours to keep.

The second reason for spread-betting’s popularity is that you can trade on margin. You don’t actually buy the shares; you bet on the direction of the price of those shares. And you can bet any amount; you could bet £5 per point that Microsoft’s share price will rise, or you could bet £500 per point. The more you bet per point, the faster you could make money, but also the faster you could lose it, of course.

But whereas you’d have to be a millionnaire to buy enough Microsoft shares outright to guarantee that you’d make or lose £500 per point of price movement, you’d only need a small percentage of the total price of the shares to trade the same amount through spread-betting. It’s an exciting way to trade, but unlike a conventional share-trading account, you could potentially lose more than your initial deposit.

And the other important factor with spread-betting is that you’re not limited to shares. You could trade the movement of the FTSE as a whole. You could trade the price of gold, or coffee, or pork bellies, or the Nikkei index, or the Dow, or oil futures, or almost anything else that is bought and sold in high enough volumes.

You could even make money from falling house prices. Some of the spread-betting companies allow you to short the price of houses, based on future contracts, usually 3, 6 and 9 months ahead, although some may allow you to bet a year or more ahead.

It may not be worth doing so, however. For a start, the spreads are huge, so you’re instantly facing a major loss as soon as you open your trade. And second, you usually only have the choice of ‘UK’ or ‘London’, measured using one of the main house price indices such as the Halifax.

So even if you know for sure that house prices are falling in your neck of the woods, you can’t capitalise on this unless they’re also falling across the UK as a whole (or all of London, if that’s where you live). For anyone seeking to hedge against the falling value of their house, this is probably not the way to do it.

But there are plenty of things worth trading, either short or long. It’s unlikely that the world’s stock markets have completely recovered yet, because there is almost certainly more bad news to emerge from financial companies over the coming weeks and months. So you can expect plenty of volatility, during which you could potentially make money on both the ups and the downs. Or lose it.

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