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

What is Short Selling?

I discussed this briefly in a piece earlier this year on the whole Gamestop incident, which essentially consisted of a short squeeze against hedge funds that had bet against the company. Most people, even those who are active amateur traders, have no idea how short selling works, yet it’s still fairly common to hear people remark that they should ‘short’ something. To most of these people, shorting just means “I’m betting that a particular company’s stock is going to decline in price,” but they don’t understand the mechanics of how that works.

In Defense of Short Selling

Some people think that short sales are uncouth, as if every company should only ever increase in value. This is not realistic or even desirable. If company values only went up, there would be no market because there would be few or no sellers. Also, the stock of legacy businesses which don’t innovate would stay up indefinitely. Such companies may even be able to keep issuing more shares and raising new money despite not innovating, thus depriving society of technological advances by misallocating capital. Securities prices must move up and down in order for markets to function and society’s technological capabilities to advance.

You Probably Shouldn’t Short Sell

So if short selling is so good, why shouldn’t people do it? Again, what you choose to do as an individual is up to your specific risk tolerance, experience, and goals. However, I do believe most people shouldn’t participate in short selling. Here’s why:

  • 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.

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Nick Gausling

Nick Gausling

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