What are the Risks of Shorting Stocks?

Short selling, or shorting stocks, is a strategy stock traders use to make money in the stock market when they think things are going to be going south. Shorting stocks is kind of the opposite of “buy low, sell high.” When a trader is a short seller, they profit when a stock they are shorting declines.

When you short a stock, you are actually borrowing shares today, and then buying the same stocks back on a later date to “cover” your position. Assuming you purchase the shares when the stock price has declined since you borrowed them, you’ve made a profit. Otherwise, you have to buy them back at a higher price and you lose money. All of those who predicted a decline in the stock market at the beginning of 2008 and shorted the market are sitting fat and happy right now.

To illustrate the concept, look at the example given by Investopedia:

Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. You decide to take the plunge and short 100 shares. The transaction is straightforward – most online brokerages will have a check box that says “short sale” and “buy to cover.”

One of two things can happen in the coming months:

The Stock Price Sinks
(stock goes to $40)

Borrowed 100 shares of XYZ at $65

$6,500

Bought Back 100 shares of XYZ at $40

-$4,000

Your Profit

$2,500

-

The Stock Price Rises
(stock goes to $90)

Borrowed 100 shares of XYZ at $65

$6,500

Bought Back 100 shares of XYZ at $90

-$9,000

Your Profit

-$2,500

The short selling strategy is a bit more complicated and often more confusing than simply buying stocks that you think will go up in value (or going long). Shorting stocks also comes with its risks.

  • Since you are borrowing the shares, you do not earn any dividends. In fact you technically owe the owner of the shares any dividend payments.
  • If the stock splits while you are shorting them, you now owe twice the shares at half the price.
  • Profits are considered short-term capital gains, which can be taxed as much as 35%.

Why Short Selling is Not a Typical Strategy for Investors

Notice that I mentioned that stock traders short stocks, not investors. That is because investors do not play the short selling game for a number of reasons:

  • Short selling is a high risk game that resembles gambling.
  • Shorting a stock requires buying on margin, and the risks entailed when borrowing on margin constitutes a whole other topic.
  • Investors are in the business of buying companies that have long-term shareholder value. Short selling requires speculation that the share price is going to decline in the short term.
  • Investors find ways to minimize fees and taxes in order to obtain the greatest return on investment. Paying short term capital gains tax rates requires a much great return on the investment to actually experience a gain after paying taxes. This, in turn, increases risk.
  • Investors are in for the long-term, and historically stocks trend up and appreciate over time.
  • When you short a stock, there is no cap on how much you can lose. There technically is no limit on how high a stock’s price can go, and stock shorters owe money as values increase. On the other hand, when you “go long” on a stock, the maximum amount you are risking is the money you invested to purchase your shares.
  • Even if you are right about the direction the stock will go, there is no telling how long that could take, and holding a shorted stock is a risk in itself because the broker can call it back if needed.

Why Would and Investor Short Stocks?

There is one circumstance that shorting a stock could be a wise move for an investor, and that is when used as insurance. In other words, an investor may short a stock in order to protect from losses. For example, if an investor owns a long position in MSFT and is afraid that it may go down in the short term, they can add a short MSFT position to their portfolio so they offset any loses. This is known as hedging your investment.

The bottom line is short selling is an advanced stock trading strategy that should not be experimented with by the inexperienced investor. Predicting the short-term direction of a stock and timing the market is not an easy task, if consistently possible at all. Betting against the historic uptrend of the market is also a loser’s game.

Millionaire Money Habit: Investors put their money on things that are as close to a sure thing as possible in order to limit their risk and increase their earnings potential. Shorting stocks is a speculative move that is too dangerous for the prudent investor that wants to build long-term wealth.

To learn more about making money in the stock market, get the Market Master Trading Course.

One Response to What are the Risks of Shorting Stocks?

  1. Eddie Smith says:

    You are wrong in your analysis of why shorting is not for a typical investor and why someone would short a stock.

    If you understand the fundamentals of a company, both a short and long position are not gambling on the security. If you do not understand a company, both positions are akin to gambling.

    Additionally, while investors should pursue long term value, being long is not the only way to pursue this value and being short is not pure speculation. There are short ideas that may take equally as long to play out as a long position but are both worth the investment. There are some fantastic companies out there that will create long term shareholder value but are shorts nonetheless. Remember, their current stock price may be in excess of what it is worth today.

    In regards to movement of the market – yes the market moves up and inflation works against you. This adds risk to your investment that needs to be considered. However that does not mean that shorting a particular security at a particular price is a bad idea. For example, if the lowest rate that a bond can pay is zero (it can go below but for argument sake lets assume that it is), shorting .001% yield bonds is a good idea. Rates only have one way to go – and they eventually will.

    Your other concerns are valid but the ultimate conclusion rests on the price of a security. If the company that owns the local Chinese food restaurant on the corner of the block (and nothing else) is selling for $100B valuation, I am shorting it.

    As to hedging risk by shorting, ff you are afraid that the price of a security that you are holding will go down in the near term, you should not sell its short while continuing to own it. This is the same as selling the security and you should go ahead and just sell it today and re-buy it later. There is no reason to own a security while borrowing it on margin from your broker.

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