Alternative Finance Series: In Defense of Short Selling (and Why You Probably Shouldn’t Do It)

This is the second article in a series on alternative finance. In the previous piece I talked about asymmetric positions in investments and trading, and one potential method for leveraging them (the Barbell Strategy). Now we’re going to talk about short selling. How is that alternative finance? First, shorting has a negative reputation in a lot of circles and we’re going to explore why it’s undeserved. Second, I’m going to explain why shorting is still typically a bad idea for most investors or traders.

DISCLAIMER: This article is provided solely for informational purposes and should not be construed as personalized investment, trading, or financial advice. I make no representations or warranties of any kind as to any of its content or the accuracy thereof. All investments carry risk, and you should consult with your financial advisor, accountant, and/or attorney prior to making any investment or trading decisions.

What is Short Selling?

When you short a security, you are borrowing an asset that is owned by someone else and immediately selling it. This process is facilitated via your broker. Of course, there’s a limited supply of assets available for lending, so some securities are difficult to short sell (these are sometimes marked in your brokerage account as ‘hard to borrow’ or something similar). But for the sake of discussion, assume you’re shorting a highly-traded stock with a lot of available short inventory. The broker lends you a stock which belongs to someone else. You immediately sell it on the open market and get paid, thus opening the short position. However, you now have a debt to repay the lender. The idea behind the trade is that if the security declines in price, you can go buy back the number of shares that you owe on the open market for a lower price and return them to the lender, thus closing your short position. The profit is the difference between the money you made when you opened the short, and the price at which you closed the short.

In Defense of Short Selling

The criticism is usually that short selling puts downward pressure on the stock price. So what? If a trader thinks a stock is overvalued, then of course their investment thesis is that the price should go down. Selling a stock you already own also puts downward pressure on the price and often for similar reasons, but nobody is out there arguing that selling your shares should be banned.

If you look closely, you’ll find that some of the most vocal critics of short selling are public company CEOs and other senior executives whose stocks are being heavily-shorted. Of course they don’t want people shorting their stocks because it makes them look bad to the Board of Directors and powerful activist shareholders, and also impacts their personal compensation (which is often largely comprised of stock grants or options).

Short selling also has a very important social benefit: it keeps the stock price of weak companies from running amok. Those familiar with the whole Jordan Belfort / Wolf of Wall Street story probably understand the basics of pump-and-dump schemes. Low-quality companies are hyped up to increase the price, at which point current owners (often company founders/executives or shady brokerage firms) unload their shares at the high. When it later becomes apparent that the company can’t deliver on the promises, the stock crashes, leaving later investors holding the bag.

Pump and dumps in the old style like this from the 80’s and 90’s aren’t as common anymore, but they still exist, albeit usually in different form such as ‘paid stock promotions’ (which aren’t always bad, but are a common vehicle for pump-and-dumps). Even large cap mega corporations can engage in a gray area form of pump-and-dump by using corporate PR or earnings calls to make promises about future successes which they have no real basis for believing will pan out. When Wall Street analysts get bought into those promises, they will rate the stock a ‘buy’ and institutional investors (hedge funds, pension funds, mutual funds, etc.) and even many retail investors will pour into the stock, pushing up the price. This drives up the value for those senior executives with large stock compensation plans and other powerful shareholders, who can then sell off their shares for greater profit. If management’s promises wind up not coming to fruition, it doesn’t matter; they already made their gain.

Short sellers are an answer to this. By going against the grain and betting against a stock, they are putting downward pressure on the price to keep it from going unreasonably high. Short sellers are often the people who are digging deeply into a company’s operating performance, financial statements, and SEC reports to diagnose where there might be problems that others aren’t seeing. As a result, they are unsung heroes who help keep public company senior executives in check.

Granted, there are improper (and illegal) tactics that some short sellers use, like spreading false, defamatory information about a company to make its price crash. Obviously this is not a good thing, but it’s also not the norm. There are bad tactics that can be used in almost any market context; that doesn’t mean the concept itself is inherently bad. If it weren’t for short sellers, there would be a lot less balance keeping the senior leaders of public companies from promising the world regardless of their ability to deliver.

You Probably Shouldn’t Short Sell

1. You enter a debt position. There are two main types of brokerage accounts: cash and margin. With a cash account, you can only trade the money you actually have. Unless you’re a professional investor, using a cash account is probably a good idea because your losses will always be limited to your account balance. In a margin account, you are taking on debt; your broker is extending you a line of credit which exceeds your account balance and will charge you interest when you use it. All short sales must take place in a margin account. Most people can’t even handle credit cards responsibly, so unless you really know what you’re doing, you probably shouldn’t be taking on debt to make investments.

2. Your maximum gain is limited, while your maximum loss is unlimited. Few people understand this. The most money you can ever make by shorting a stock is what you get when you open the position. The profit is the difference between that price and when you close the short. If you open a position at $50, the most you can possibly make per share is $50 and that’s only if the price drops all the way to $0 when you close the short (unlikely). So if you open at $50 and your thesis is the price will drop 10%, and you’re right, you’ll make $5/share and no more.

People familiar with the (small handful of) wildly-successful short sales made during the housing crisis might be thinking in terms of the massive gains earned by some of those traders, but that’s because most of them were professional institutional investors and started with massive accounts balances to begin with. Also, there were unique nuances to those types of trades which involved incredibly complex derivative products previously unknown to the world of finance. In other words, that’s a completely different ball game; as an individual amateur trader, you aren’t going to make a million dollars shorting a stock in your $10,000 account.

Meanwhile, the loss potential on a short is unlimited, because there is no upper bound on a stock price. Let’s say you’re wrong and the trade goes against you. If the price increases to $60, $75, or $1,000/share, you’re still responsible for paying off the debt. And by law, you must maintain a minimum value in your margin account relative to the total portfolio value. As the price on your shorted stock goes up, your account value goes down; if it drops far enough, you may receive a margin call to add more assets to the account in order to cover the credit deficit. If you can’t cover the short, your broker will start selling off other securities in your account without your permission to generate cash, since if you default on the debt they are responsible for paying it off. Yes, it’s legal for your broker to force-liquidate your assets in this scenario, and no, you can’t do anything about it. In some cases, they can do it without even giving you a chance to cover the short. You may also get caught in a short squeeze where others who are short the same stock are rushing to close their positions, creating a spiral where the stock price is rapidly pushed higher by the buying activity and you are struggling to get the shares you need to close.

3. Your broker might lend out YOUR assets to other short sellers. If you create a credit position by taking on a short sale, your broker often has the right to rehypothecate your shares in the stocks you personally own, meaning they will take your stocks and loan them out to other people to short against you. If you read through the disclosure documents in your brokerage account you’ll usually find this spelled out, but most people have no idea it even happens.

4. You might incur additional liabilities in the form of dividends. If the shorted company issues a dividend, you will owe that full dividend back to the original lender, meaning your liability may grow beyond what you planned for with the interest rate on your margin loan.

5. There’s more conservative ways to bet against a company. You can accomplish basically the same underlying purpose of a short sale with much more conservative methods. To name just a couple, you could:

  • Buy stocks of competitors. If a company you’re betting against does poorly, and the reason is because of things specific to that company and not the industry as a whole, competitor stocks may rise. Going long like this also has the advantage of being an asset with unlimited potential upside.
  • Buy put options. Options are derivative instruments and can quickly become just as complex and dangerous as short selling (if not more so), but they can also be used conservatively. A put option is a security contract, typically traded in lots of 100 shares / contract, that gives you the right to sell an underlying asset at a certain strike price before the contract expiration date. For a set price (the option ‘premium’), you can buy a put option contract on the open market. If you’re wrong about the stock’s decline and the option expires worthless, the most you will have lost is the premium. If you’re right, the price of the put option will likely have upward pressure as the underlying stock price goes down. You can then re-sell the option on the open market before the expiration date or, if you choose, you can actually exercise the option. Buying and selling options via your broker is very similar to buying selling stocks.
  • For example, a stock is trading at $50. You buy a put option for the right to sell the stock at $45 sometime in the next three months. If the stock price drops below the $45 strike, the option is considered ‘in the money.’ You could then go into the open market and buy the shares at the lower price, exercise the option, and resell them at the strike price, pocketing the difference. Or you could simply re-sell the option on the open market (possibly to some other buyer who does intend to exercise it).
  • Note: If you’re going to exercise a put option, counter-party risk is minimal since the Options Clearing Corporation will assign someone else on the other side of your trade (i.e., someone who sold the same type of put option that you bought) to buy the stocks from you. However, you may run into volume/liquidity problems when trying to sell back certain options on the open market. There are also other factors that may impact option pricing regardless of the underlying asset direction, such as time to expiration (options usually face downward price pressure as they get closer to their expiration date). What I’m talking about here are broad concepts, not specific strategies. Be sure you understand how options work and what you’re doing before you try this, and only trade in options with sufficient volume/liquidity. Though in general, if you’re trying to bet against a company, the point is that buying a put option is usually a much more conservative method than short selling.

Short selling is a great thing for markets and the public; it’s just typically not a great method for most individual investors or traders. Be thankful for the short sellers out there, but unless you really know what you’re doing and are comfortable with the substantial risk involved for limited profit, it’s probably best to not attempt it.

This story was initially published on NickGausling.com

ALTERNATIVE FINANCE SERIES

Part 1: Asymmetric Positions & the Barbell Strategy

Nick Gausling is a strategic business leader, author, speaker, and investor currently residing in Texas. He can be reached via NickGausling.com