Why Shorting Is Risky (Why Short Selling Is Difficult And Why You Shouldn’t Short Stocks )

Last Updated on November 12, 2021 by Oddmund Groette

Recently the short squeeze in Gamestop and some other stocks have attracted a lot of media attention. Of course, the action in Gamestop is sheer speculation and most likely a short attack on stocks with limited float and high short interest. This is expected to continue for some weeks, and some hedge funds are likely to suffer large losses, which implies huge profits for many of the individuals buying these stocks.

However, the last to join the party will likely suffer losses when the frenzy is over, and the valuations return to normal.

This article explains why shorting is risky and difficult and why you shouldn’t short stocks. We explain how a short squeeze develops, why short sellers face potentially unlimited losses from tail risks, and what makes shorting such a challenging endeavor. We explain how short selling works.

What is shorting a stock? How does short selling work?

When you own a share, you own a small piece of a (public) company. When you don’t want to be a part-owner of the company, you sell the shares via your broker for a small fee. This is a concept everyone understands.

But when you short a stock, you are selling something you don’t own. How on earth can you do this? The rules specify you can’t sell something you don’t own – this is called naked short selling and is illegal. If you have no shares in Microsoft, your broker makes it impossible for you to sell it. The reason is simple: The number of outstanding shares is given. You can’t sell shares short that don’t exist.

However, you can borrow shares from someone else and sell those shares. That is perfectly legal. Here’s how it works:

Investor 1 owns 500 shares of Microsoft. He is a long-term shareholder but would like to get an additional “income” by lending his shares to short-sellers.

Investor 2 suspects Microsoft is overvalued and wants to profit from the decline in share price by selling short. Investor 2 learns from his broker’s website that he can borrow 1 000 shares at 5% annual interest. He agrees to borrow 500 shares (and the broker borrows from investor 1), and Investor 2 subsequently sells the shares in the market for 230 dollars per share. He is now short 500 shares in Microsoft, which he later needs to give back to his broker (and the broker to Investor 1).

One year later, the share price drops to 200, and Investor 2 buys back the shares. He pockets the difference (230 minus 200 times 500 shares). While being short Microsoft, Investor 2 has paid 5% annually for borrowing the shares. Obviously, if the share price had risen to 300, Investor B would have lost the difference between 300 and 230.

What happens if the stock pays a dividend? The investor being short receives the dividend but is, of course, obliged to give it to investor 1, who is the owner of the shares.

Who gets the interest paid by the short seller (Investor 2)? It depends on the broker. Most of it is normally received by the broker, but a small part goes to the investor who agrees to lend his shares.

When an investor agrees to lend out shares, it gets “pooled” by the other shares from other investors. Short-sellers can easily check the availability and costs before they short.

What is short covering?

A frequent word in the financial media is short covering. When the short seller (Investor 2) buys back the shares he previously sold to return them to the broker and Investor 1. If he or she is short 1 000 shares, he buys back 1 000 shares in the market to cover or liquidate his position.

Short selling in the derivatives market

The derivatives market is different from the stock market: it’s a zero-sum game. For every contract, someone is long, and someone is short. When you, for example, buy a call option in Microsoft, someone else must issue that contract. What you gain on the deal, someone else must lose.

We have witnessed numerous short-squeezes throughout history. What is now happening in the stock market frequently happens in the derivatives market.

Shorting involves unlimited losses and tail risk- why you shouldn’t sell short

The action in Gamestop illustrates the dangers of short selling and why you shouldn’t short individual stocks:

While the share price can only fall 100%, there is, in theory, no limit on the upside. In August 2020, Gamstop was trading at five dollars, but six months later, it sells at 325 dollars!

That’s a 6 500% loss for someone who shorted at five dollars. Thus, the gain was capped at a maximum of 100%, but instead, short-sellers lost 6 500% percent. That’s a pretty bad risk/reward.

Short selling involves tail risk:

Short squeeze explained – tail risk

I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”

– Victor Niederhoffer, The Education of A Speculator, page 267-268.

The quote above from Victor Niederhoffer explains pretty well the dangers of selling short: you risk a short squeeze and being forced out of your short position.

Short covering adds fuel to the fire because short sellers need to buy back shares to return them to the owner. Short sellers must deposit collateral by their broker and be forced to cover their position or come up with more collateral if the position goes against them. And, as illustrated in the quote by Niederhoffer, short sellers give in at the same time when they can’t take the pain any longer. It’s a vicious cycle.

When the amount of shorted shares is high compared to the outstanding shares, it’s not easy to cover the short position. If a fund is short 500 000 shares and the daily turnover is 100 000 shares, it would take more than five days to buy back the shares. The window of opportunity is small, and the door for the exit might not be wide enough.

Moreover, when selling short, you face the risk of the shares being called-in by the broker, for example, if the broker faces reduced inventory, which could happen when its clients start selling their shares.

Alternatives to shorting a stock

Because the potential losses are unlimited, most investors should stay away from shorting. Is there an alternative? Luckily, yes. You can make a long position by purchasing puts.

What is a put? A put is an option contract. A put option offers you the right to sell a stock at a predetermined price (it’s not an obligation to sell). To get this right to sell, you need to pay a premium. The price of the premium depends on many factors and is outside the scope of this article. But it’s a long position, and you can still benefit from a falling share price.

The main advantage with a put is that you limit your exposure: your maximum loss is the premium. For example, if you paid one dollar for each contract, 1 000 USD for 1000 shares, your maximum loss is 1 000 USD. Compare this to being short 1 000 shares in Gamestop – a loss of 320 000 in six months! The limited loss happens because you are long a put option. You have no short position.

Why short stocks?

After reading all the negatives and risks of short selling, the reader might ask why some investors still sell short. Below are some arguments for why short sellers keep on trucking:

Short-selling as diversification

Someone who has proven himself as a successful short seller will be in demand among institutions. The reason is diversification and portfolio theory. A fund specializing in short selling might add huge benefits to a long portfolio by smoothing returns and increasing the “efficient frontier”. For example, an endowment fund might allocate 2% of assets to a short-only fund. The aim is that the short position should limit losses when the markets fall.

Short-selling as a hedge

Hedge funds like to balance their bets by, for example, 70% long and 30% short, for a variety of reasons. Some others might want to be 100% neutral and only profit from the difference between the long and short positions.

A stock might be overvalued

Many stocks are overvalued. To make a market, we need different opinions. Short sellers help to balance the market.

Short sellers look for financial fraud

Many hedge funds specialize in financial misconduct. They scrutinize balance sheets, accounts, and look for irregularities. Fraud is everywhere.

Why you should not short stocks

The arguments for not shorting stocks are many:

The market rises over time

The upward drift in the market has proven to be around 9% per year, according to Dimson, Marsh, and Staunton in the Triumpf of the Opmimists. By being short, you are betting against inflation and corporate profits, and perhaps even multiple expansion. Why bet against this? Add the borrowing costs, and it gets pretty evident the cards are stacked against short sellers unless you are a speculator of extraordinary abilities.

Timing is everything

Most of the time, the market drifts upward and occasionally drops hard. This means short selling is very much an exercise in timing, which of course is very difficult. A market can remain irrational longer than you can remain solvent, according to Maynard Keynes. Warren Buffett made the same conclusion a long time ago: you can’t predict when an overvalued stock pops.

It costs money to borrow shares

You need to pay interest on the shares you borrow to sell short (see more below).

The risk/reward is bad for the short sellers

A short-seller can only make 100%, which is highly unlikely, while the losses in the worst cases can be unlimited.

Bull and bear markets have different velocity

First, a personal anecdote: I was a day trader from 2002 until 2018. 2008 was my best year, by far, even though the market was down 55% at the most. Surely it must have been shorting that made the difference? No, I made about 2x times on the long side compared to the short side.

Why is that?

The reason is the velocity of a bull and bear market. A bear market discounts a bleak future fast, while a bull market rises slowly and over time. Moreover, bear-market rallies are very explosive. Let’s repeat some data I have published many times: the S&P 500 from May 2008 until the bottom in early March 2009, a period in which the S&P 500 lost about 50% of its value:

  • There were 99 up days and 104 down days during that period.
  • The average up day was 1.79%. The average down day was minus 2.32%.
  • From May 2008 to early March 2009, it was 51 days with a rise >1%, 30 days with a rise >2%, 76 days with losses >1%, and 45 days with losses >2%.

Even though the market fell sharply, we witnessed many explosive days on the upside. This is what makes shorting so difficult. Volatility explodes during bear markets. Below is the graph showing a 25 day moving average of the absolute values in the daily changes from close to close:

The S&P 500 had daily swings of 4.5% in the midst of the recession! The up days were significant, and this is what makes short selling difficult: timing of both sale and buy to cover when markets are moving fast.

Shorting is painful

As usual, Charlie Munger offers some insights about short selling: “Is the pain, worry and mental distractions of shorting worth your time?  It is not that “hard” to make money somewhere else with less irritation.”

What is a stock that is hard to borrow?

Every broker has a list of stocks that is either easy or hard to borrow. As written earlier in the article, you need to locate shares before you short them by selling them in the market.

Those investors who own shares might agree to lend them out for short sellers. For doing this, they receive interests, usually split between the broker and the investor (the broker pockets the most). This means the broker’s ability to short stocks is dependent on both the holdings of their clients and their willingness to lend out their shares.

If the supply is short, the broker might have a deal with another broker. It’s a network effect. Those brokers who have the biggest inventory attract the most short sellers.

Hard to borrow means that the stock is difficult to short, and you can expect to pay more for the privilege of shorting. When a stock is hard to borrow, you need to pay more to locate the stock. This means the interest charged increases.

Below is a copy of Interactive Broker’s inventory of Coca-Cola:

 

Interactive Broker’s inventory on Coca-Cola (KO).

More than 10 million shares are available for shorting, making Coca-Cola easy to borrow.

A stock that is easy to borrow, has low fees.

What about Gamestop? This is the rates and availability for a select few days at Interactive Brokers:

The costs of shorting are substantially more costly in Gamestop than Coca-Cola.

In general, the factors that influence the costs are the Fed Funds rate, liquidity of the shares, the short interest as a percentage of the daily trading volume, and the short interest compared to outstanding shares (brokers are afraid of a short squeeze).

Short sellers attract the wrong shareholders

It takes lots of time and effort to attract and educate competent shareholder/partners. The last thing we want them to do, is sell.

– Mark Leonard, Constellation Software, shareholder letter 2013

The shareholder base is an underrated aspect. A business owner doesn’t want his company exposed to activists. Short sellers are mainly speculators and activists, and are never thinking long-term. Short squeezes are very destructive and counterproductive, thus scaring off many long-term owners.

Warren Buffett has spent considerable time educating his shareholders. He wants them to think like owners. If you’re a long-term investor, you shouldn’t spend any time at all thinking about shorting.

Conclusion

It’s hard to make money on short selling and that’s why you shouldn’t short stocks. You face an uphill battle that involves unlimited risk, even tail risk, and on top of that, you are liable to short squeezes. If you still want to make a bet on the downside, we recommend buying puts.

 

Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.