Clearing Up Big Misconceptions About Shorting: My Idea For Italian Bonds

| About: PowerShares DB (ITLY)

I'll get right into it: many of my readers had some questions about my piece earlier this week on shorting Italian bonds to profit from the country's debt crisis. This isn't the typical 'income story' that government issued bond investors expect to read. But it's important that all bond investors understand the risks that come with buying government issues securities, especially when that government recklessly spends money.

The premise: Italian bond yields are on the rise. When yields rise, bond prices plummet. So we can make money shorting bond prices. As I wrote: "The easiest way to short Italian bonds is to sell shares of the PowerShares DB Italian Treasury Bond ETN (NYSE: ITLY)."

Among the questions I received, I also got some very interesting (and heated) commentary from an Italian reader. He wrote:

You are shorting = slaughtering us. you do NOT short the UK, your friendly relatives after all...this is what I call the anglo-saxon mafia, the white collar one.

So before I get into the questions on shorting, I'd like to clear up one big misconception about shorting - which my Italian friend seems to believe in wholeheartedly. The misconception? That shorting causes prices to fall. It's a total myth. It's no truer than the idea that buying an asset makes prices rise.

No one would seriously claim that buying forces prices up. But even the mainstream financial media can't avoid this myth. Short-sellers are seen as the cause of falling prices. They're called vultures, assassins, ninjas, predators, leeches and slime balls. People fear short sellers. But as with all things that people fear, it's only out of ignorance. Most people just don't understand how short selling works.

But it's an incredibly valuable tool that should be in every investor's toolbox - even bond investors'. Being a long only investor is like having a car that doesn't go in reverse. The market rises and falls. You can make money when it rises, just as you can make money when it falls. Don't limit yourself to half of the opportunity.

Here is another reader question:

I recently read your article How to Profit From Italy's Fall. In the article you said to sell PowerShares DB Italian Treasury Bond ETN. I am new to the investment world and would like to know what you mean by "sell." Are short investments meant to make a quick profit? And is this a good investment for someone who is new to the market and has little money? - GB

GB, normally if you think a stock or other investment will go up in price, you'll buy it now - then sell it later once it has gone up in price.

But shorting is the opposite. You believe something will fall in price, so you borrow shares (from your brokerage) to sell now. Then you buy them back later (to repay your broker the borrowed shares) when the price is lower.

It's kind of confusing at first - but think of it this way: you only make money when you remove your exposure to an investment. But instead of buying low, then selling high, you're selling high, and then buying back low. At least, that's your goal. Selling high is the key. It doesn't matter when you do it, as long as your selling price is higher than your buy-back price.

As for your question about the duration of a short, yes - they do tend to be shorter term investments. But that's only because investments have a general tendency to fall faster than they rise. And, ironically, that has everything to do with the fact that most people do not short stocks. So when an asset is falling there's a tendency for "long" investors to hold and pray. Eventually, they sell, but only after the asset already fell hard.

And for your last question, I know that most investment advisors will probably have a coronary when I say this - but yes, shorting investments should be something that new investors use - for the simple reason that it's somewhat easier to find assets that are likely to fall.

Shorting is just as easy as and no more risky than buying a stock. Instead of selecting "buy to open" or "buy" in your online brokerage, you select "sell to open" or "sell." You'll need to open a margin account to sell short. It's possible that you won't get filled. It depends on your broker, the volume of available shares and a few other factors. But if you're unable to short, I'd suggest calling your broker and asking them what you need to do in order to be able to. Don't let anyone tell you that you shouldn't short stocks.

Again: shorting something does not make the price go down. And when short-sellers buy those bonds back to close the trade, it will actually be a great relief to people who want to sell. Who else would buy bonds after they fall 50%?

Without short-sellers, the price of Italian bonds would likely drop even further.

Disclosure: None.