Winter is coming. Literally, yes. But possibly also for AIM. Since October 2018, we have seen the small cap space relentlessly hammered down and beaten. The underlying trend has predominantly been either sideways or down.
That’s not good for long only traders. And it’s not good for market sentiment in general. People who blow their accounts aren’t in any hurry to come back – they know what it’s like out there. And fewer traders, means less liquidity, and less liquidity means wider spreads. Wider spreads in turn put off traders.
Now, with many AIM companies depending on cash injections to advance projects and keep the lights on, it’s no surprise that investors taking placings have their pick of the pie. They know the companies need cash, and when a company is on its knees, well, you can really make them scream. And don’t the brokers know it! It’s discounts galore for placings.
However, we can profit from this trend, because shorting is an option that is available to us.
By identifying companies with incredibly weak balance sheets and who are low on cash, there are opportunities to short these and take advantage. At the end of the day, money can be made long or short and there is no reason why we can’t profit from this going short.
Shorting gets a bad reputation, because hypothetically one’s losses are unlimited. But with the new EMSA regulation, which many forex traders complained about because it drastically reduced the amount they were able to use as margin, spread betters no longer have to worry about going into negative equity – unless you sign up as a professional, in which case you can.
As well as shorting individual companies, we can short indexes too. The FTSE 100 is a basket of the largest UK stocks by market capitalisation; however, many of these report in dollars and have global operations, so are not as readily affected as many smaller UK companies.
One of the big problems of shorting the FTSE 100 is that it is so heavily weighted to just a few stocks. Shell, Unilever, HSBC, BP, and AstraZeneca are worth more than the bottom 20 constituents of the FTSE 100 alone. So, any short on the FTSE 100 is going to be correlated mainly to how well these big businesses perform.
The FTSE 250 is a better index to short, as it gives a better version of reality compared to the AIM market. It’s still not perfect, but most of the companies report in Sterling and not all of them are global operators. It’s very much a UK based market, and for investors being short an index is a handy way of getting short exposure.
I have never really understood why someone long Royal Dutch Shell only would wish to hedge that position by shorting oil. Whilst the two are undoubtedly correlated, selling half of Royal Dutch Shell would be better – cash is the perfect hedge. You’ve reduced your exposure, and also lowered your risk.
However, if you own 40+ stocks, then selling half of 40 stocks is not only laborious but expensive in terms of dealing fees. Even if each trade is only a fiver, that’s £200 just to hedge (and £200 if you want to buy it all back too!)
You could just hedge your largest positions and sell half, but then what if liquidity is poor?
The FTSE 250 can be a good shorting index – it’s worth checking how correlated it is against your current portfolio. You can do this with SharePad.
Winter may be coming, but that doesn’t mean we shouldn’t be prepared.
Author Michael Taylor’s website www.shiftingshares.com contains numerous tutorials on how to trade and invest as well as his free book – ‘How to Make Six Figures in Stocks’.