“Short selling, it’s an interesting item to study because it’s, I mean, it’s ruined a lot of people. It is the sort of thing that you can go broke doing.” -Warren Buffett
“It isn’t that hard to make money somewhere else with less irritation.” -Charlie Munger
Quotes from two of the wisest people in investing around short selling. They’re not wrong. As briefly discussed in Lesson 47, short selling is extremely hard and involves a lot of risk. There are only a subset of traders and investors that can successfully execute shorting strategies, while there are many that try and end up losing a lot of money in the process. I thought this would be an interesting topic to discuss here in this post.
Short trading, or shorting, involves profiting from the decline in the price of a security rather than its rise. This trading strategy involves an investor borrowing shares of a stock from a broker and sells them on the open market with the expectation that the stock's price will decline. The investor then aims to buy back the shares at a lower price, return them to the broker, and pocket the difference as profit.
Let’s go through an example to demonstrate. My friend Jim owns a chair worth $100. I borrow Jim’s chair, and I tell him I’ll give it back to him in 6 months time. I sell it on Facebook marketplace for $100. Over the 6 months, the value of the chair that I borrowed from Jim goes down, and I see it pop up on Facebook marketplace for $80. I buy it back, and I give it back to Jim at the end of the 6 months. Jim never lost ownership of his chair, but I managed to realize a net gain of $20 from the selling and buying back of Jim’s chair.
Now translating this to the stock market, executing a successful short trade would involve the following steps:
Borrowing Shares: The investor borrows shares of the desired stock from their broker, typically facilitated through a margin account.
Selling Shares: The borrowed shares are immediately sold on the open market, generating proceeds for the investor.
Waiting for Price Decline: The investor waits for the price of the stock to decrease, ideally maximizing their potential profit.
Buying Back Shares: Once the stock price has fallen to the desired level, the investor repurchases the shares from the market.
Returning Shares: Finally, the investor returns the shares to the broker, closing out the short position.
As you’ve probably already noticed, the success of this strategy depends on the price of the shorted stock to decline. If the price increases, then that is bad because now you have to buy the stock back at a higher price than the price you sold it at and received proceeds for. You’ll be net out a few dollars after buying it back at a higher price.
Despite the risks (which we’ll go over here in a bit), there are benefits to short selling that investors seek out. These include:
Profit from Declines: Shorting allows investors to profit from falling prices, thereby diversifying their portfolio and hedging against market downturns.
Portfolio Hedging: Short positions can serve as a hedge against long positions in a portfolio, mitigating potential losses during market downturns.
Diverse Strategies: Shorting opens up a plethora of trading strategies, including pairs trading, arbitrage, and market-neutral strategies.
While there are advantages, which I would argue can only be pulled off by experienced investors, there are many risks that come along with shorting. Yes a stock can go up in price, but in theory in can go up indefinitely - the lowest a stock can go is $0, but the highest is infinity.
Unlimited Losses: Unlike buying a stock, where the maximum loss is limited to the initial investment, shorting carries the risk of unlimited losses if the stock price rises significantly.
Margin Calls: Shorting on margin involves borrowing money from the broker, which can lead to margin calls if the stock price rises sharply, requiring additional funds to maintain the position (more on short squeezes below).
Timing Risk: Shorting requires precise timing, as the investor must accurately predict when the stock price will decline. In a bullish market, timing the downturn can be challenging.
Interest Costs: Borrowing shares to short often incurs interest costs, which can eat into profits, especially for longer-term short positions. This is elaborated on below under Stock Borrowing Costs.
Shorting may sound like a feasible strategy for beginner traders, but besides the potential to lose money, many people may not be aware of several other factors that need to be considered in order to manage risk appropriately.
Stock Borrowing Costs: Borrowing shares to short often comes with associated costs, including interest rates and borrowing fees. These costs can vary depending on factors such as demand for the stock and the broker's policies. Investors should carefully consider these costs, as they can impact the profitability of short trades. Think about our example with borrowing Jim’s chair. Jim may want some sort of interest payment while we are borrowing the chair. This is no different than interest charged on a bank loan.
Availability of Shares: Not all stocks are equally easy to borrow for short selling. Stocks with high demand for shorting may have limited availability of shares, leading to higher borrowing costs or even the inability to execute a short trade. Investors should research the availability of shares before entering into a short position.
Short Squeeze Risk: Short squeezes occur when a heavily shorted stock experiences a sudden price increase, forcing short sellers to cover their positions by buying back shares. This increased buying pressure can further drive up the stock price, resulting in significant losses for short sellers. Investors should be aware of the potential for short squeezes, especially in stocks with high short interest.
Let’s expand on this risk item. To manage risk, brokerages will cap the amount of borrowing that an investor can take based on their portfolio balance. Brokers do this to prevent investments losing too much value that were funded on borrowed money that could actually wipe out the client’s entire portfolio, resulting in a negative account balance and leaving the broker to cover this negative balance. Any lender wants to cover their ass to prevent this kind of default-like scenario from happening. Imagine having a $100 in your account, and you borrow $200 to invest in something else. Even though you now have $300 in assets, your total account balance is still $100 because you have a negative $200 cash balance (i.e. $200 on margin). If that $200 worth of assets loses half of it’s value, it’s worth only $100. But now your account balance would be $0 because the balance of money borrowed hasn’t changed, but the asset value has changed: $300 in assets has now become $200 in assets, and $200 of negative cash balance is still the same. To avoid these kinds of scenarios, brokers will impose a “maintenance margin” or a minimum account balance that must be maintained given a particular asset portfolio size. This applies to shorting as well because you are borrowing shares and selling them, and will have a “negative” share balance showing in your account. Because a stock in theory can go up to infinity, this means that losses in theory can be infinity, so brokers essentially set a cap on how high this shorted stock can go before forcing an investor to buy back the shares and exit their short position. This waterfall effect after a stock has already gone up forces additional buying volume as shorts are forced to close to meet brokerage margin requirements. This continues to force the stock up even higher, usually in a parabolic or exponential fashion, as buying volume increases. This in essence is called a short squeeze, and the uptick rule around shorts fuels this as well.
Dividend Payments: When shorting a stock, investors are responsible for paying any dividends that the stock may issue during the short position. This can result in additional costs for short sellers, reducing their overall profitability. Investors should consider the impact of dividend payments on their short trades and factor them into their risk calculations.
To think about this more simply – you borrowed a stock from Jim and sold it short. In the meantime, the stock issues a dividend and pays it out to its current shareholders. Jim is still a shareholder of his stock that you borrowed, and he is owed his dividend. Because you borrowed the stock from him, you have to pay him that dividend.
Regulatory Risks: Short selling is subject to various regulations and restrictions imposed by regulatory authorities. These regulations may include rules on short sale reporting, uptick rules, and short sale circuit breakers. Investors should stay informed about relevant regulations and ensure compliance to avoid potential penalties or restrictions on their short trades.
Psychological Factors: Short trading can be psychologically challenging, as it goes against the conventional wisdom of buying low and selling high. Short sellers may face feelings of anxiety, uncertainty, and cognitive biases such as confirmation bias and overconfidence. It's essential for investors to manage their emotions and adhere to their trading strategies with discipline (more on this back in Lesson 30 and Lesson 32)
Counterparty Risk: Short selling involves borrowing shares from a broker or another counterparty. Investors should be mindful of counterparty risk, which refers to the risk that the counterparty may fail to deliver the borrowed shares when needed. While counterparty risk is typically low with reputable brokers, it's still a factor to consider when engaging in short trades.
Short trading can offer investors a unique opportunity to profit from market downturns and diversify their investment strategies. However, it requires careful and strict risk management, precise timing, and a thorough understanding of the market dynamics. As a result, investors should approach short trading with extreme caution and ultimately have an intimate understanding of how shorting works before engaging in this strategy. Personally, for the most part, I follow Mr. Munger and Mr. Buffet’s advice and avoid shorting altogether. There are so many other ways to become profitable in investing, and avoid an irritating and stressful strategy that can leave you holding the short end of the stick.