By: Dividend Sensei
Short selling means borrowing shares from your broker (who borrows them from someone else) and then hoping the price falls so you can buy them back at a lower price and pocket the difference. Now short selling, unlike naked option speculation, is a valid strategy that in the hands of professionals using good risk management can be highly profitable. However the key to good short selling is you need to have an edge in terms of information. Most successful short sellers (who are right 50% to 60% of the time) do vast amounts of detailed research, including forensic accounting, to discover major flaws in a company’s business model. For example the infamous case of the Enron fraud was uncovered by short sellers who were carefully scrutinizing the company’s books and determined that Enron was actually losing a fortune but covering it up via the use of off the book accounting fraud and shell companies.
Ultimately though the problem with short selling is similar to that of option speculation. You need to be right about timing, direction, and magnitude. That’s because you pay interest on the borrowed shares. What’s more if the stock pays a dividend you have to cover that to. For some popularly shorted distressed stocks like CenturyLink, Uniti Group, or CBL & Associates, they can yield up to 15%. This means that the cost of shorting the stock for a year is about 17% (15% dividend +2% interest cost of borrowing shares). That means to make money shorting a stock you need the price to implode and relatively quickly. What’s worse the most you can make is 100% on your money if the stock goes to zero. And if the shares recover? Well remember that stocks can only lose 100% but there is no limit on how they can rise. If a shorted stock rises quickly you’ll get a margin call from your broker requiring you to add money to cover your losses and maintain the trade.
Loss aversion means that many short sellers become stubborn and continue to add funds to cover their margin calls. And since stocks can rise quickly and to insane levels (those shorting NVIDIA, Netflix or Amazon in recent years have lost fortunes) you can end up losing more than your initial investment. Or to put another short selling creates limited upside in exchange for unlimited downside. And even if you’re right that a stock is massively overvalued, it can keep rising high enough for long enough to break your portfolio before it ends up crashing. In this way many short sellers have ended up being right but still losing their shirts.