How to cash in on an impending stock market crash

Have you watched the film The Big Short?

It’s hard not to feel in awe of the small group of investors, led by Michael Burry, who saw the 2008 subprime mortgage crisis coming, realised that it meant property prices would fall and bet against the housing market, making themselves hundreds of millions of dollars in the process.

Could ordinary savers do the same? Could you decide, for example, that inflation is here to stay, or that interest rates will continue to rise, or that the stock market is heading for a fall – and try to profit from your conviction?

Here, Telegraph Money answers these questions, by looking into the strange, little understood world of short-selling.

What is a ‘short’?

A “short” is shorthand for a “short position”, and is so-called because a conventional investment in an asset, such as a share, is called a “long” position.

So, if you have bought shares in Tesco, for example, you are said to have a “long” position in Tesco – or to “be long of” Tesco.

What, then, does it mean to be “short” of Tesco?

A “short” investor in Tesco expects its share price to fall and makes money if it does – the opposite of what happens to an investor who has a “long” position.

How do you become a short-seller?

You may be wondering how you can take out a short position in a stock or other asset in practice so that you can profit if the price falls. There are several ways.

The most traditional option is to borrow the asset from an existing investor and then sell it. Crucially, if you do this you owe the other investor the assets, not their value in monetary terms.

So, if I borrow 100 Tesco shares from you and sell them, I must then repay you 100 Tesco shares – irrespective of what happens to their price.

Let’s say that the price of the asset you borrowed falls after you sold the shares, as you expected. You then buy enough of the asset in the market to repay the loan at the lower price. The difference between the price at which you sold the shares and the price at which you bought them later is your profit.

The problems with this method are that there may be no one willing to lend you the stock in the first place, and that the practice is outlawed in some jurisdictions. As a result, other ways to “short-sell” have evolved.

These involve what are called “derivatives”, because they derive from underlying assets. One method is a “spread-bet”, another is a “contract for difference” (CFD).

In each case you are making a prediction of the price of an asset in the future, and will win or lose according to how good your prediction is.

Unlike borrowing shares or other assets, it’s easy to set up a spread-betting or CFD account. Popular providers include IG and City Index. A “put option” is another type of derivative that can be used to short an asset or index.

Another way to short certain assets is via a special type of investment fund geared to the purpose.

“Exchange-traded funds”, or ETFs, normally aim to replicate the performance of a particular index, but some offer returns that are the opposite of those from an index.

So while, for example, a conventional FTSE 100 ETF simply aims to rise and fall in line with that index, you can also buy an ETF that will gain value when the FTSE 100 falls.

An example is the Xtrackers FTSE 100 Short Daily Swap Ucits ETF, which trades on the London stock market under the “ticker” symbol XUKS.

If you wanted to short the American stock market instead you could buy the Xtrackers S&P 500 Inverse Daily Ucits ETF (ticker XSPS).

How to be a successful short-seller

Short-selling is one thing, but doing it to actually make a decent return is quite another.

It won’t be easy: you’ll need patience, the willingness to monitor your positions constantly and great conviction in your beliefs which, by definition, will go against the consensus (otherwise the price of the asset would already be where you think it should be and there would be no profit to make).

This is the opinion of Barry Norris, of Argonaut Capital, who runs an investment fund that takes both “long” and “short” positions.

“Short something you know something about,” he said. “You need to have an information edge over other investors. Work out what it is and what it will take for the market to come round to your point of view. That may take time, which is why you need patience.

“I start with an instinct about a particular asset and then aim to back it up with hard facts. You’ll probably need to ask difficult questions and be ready to spot the weaknesses in other people’s arguments.

“Short-sellers tend to have a particular character – if you seek consensus, don’t believe in hidden agendas and don’t have a nose for misleading waffle and groupthink, you won’t be a good short-seller.”

When it comes to the practicalities, Mr Norris said you should be diversified and very aware of risk.

“I know no-one who shorts with just one position,” he said. “You need risk controls and to take positions of appropriate size – you play probabilities like a good poker player. You need to give it your full concentration.”

Mr Norries said he knew of no way in which private savers can directly short the housing market in the way Michael Burry did, but suggested shorting housebuilders or other related sectors as a proxy. IG Group, a spread-betting firm, makes the same suggestion. The company does, however, allow customers to place bets on future inflation numbers in Britain and America.

There are several factors that can indicate whether a stock or index is building momentum downwards, including looking out for the “death cross”. The chart below shows a “death cross” for housebuilder Persimmon, which has experienced a downturn in demand for new homes.

What are the dangers of shorting?

The first and most potent danger is that of unlimited losses.

If you have a “long” position on an asset – you buy some shares, for example – the most you can lose is the amount you invested. The potential gain, meanwhile, is unlimited.

The position is reversed when you short-sell an asset: the most you can gain is if its value collapses to zero, while your losses are unlimited if it turns out you are wrong. There is no limit, in principle, to the price a share can reach.

This is all the more true if you have used borrowed money to take out a short position, as investors sometimes do.

CFDs and spread-bets are regarded as “leveraged” investments in the sense that you could lose more than the amount you originally bet.

However, investors regarded as non-professional by spread-betting companies cannot lose more than they have in their account with the firm concerned at the time – but this protection does not apply to “professional” customers.

For this reason, it’s advisable to use a “stop-loss” when you short-sell. A stop-loss closes your trade once a certain loss, chosen by you, has been made.

CFD and spread-betting companies normally allow you to set stop losses; in some circumstances they may close your trades automatically if allowing them to continue would put you at risk of large losses.

Even if you do not lose more money than you have bet, the odds are not in your favour. Spread-betters are obliged to publish warnings about the proportion of customers who lose money – and percentages of 70pc or more are common.

This is what City Index, for example, tells customers: “CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 71pc of retail investor accounts lose money when trading CFDs with this provider.

“You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.”

So, can I do my own ‘big short’?

Not directly on the housing market the way Michael Burry did (and even he didn’t find it easy).

You could, as we say above, use shares in housebuilders as a proxy.

You can, however, bet on inflation. When it comes to the stock market, it’s far easier to short-sell, via CFDs and so on, and you can use the same methods to bet on commodity prices and foreign exchange rates.

Or you can avoid CFDs and the like if you want to bet that common stock market indexes such as the FTSE 100 are going to fall by investing in appropriate ETFs.