Perils of Selling Short in the Stock Market

I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”

– Victor Niederhoffer, The Education of A Speculator, page 267-268.

What happened in Tesla over the last couple of weeks serves as a great reminder of the perils of shorting: fat tails, randomness and erratic moves.

Risk and reward

If you are long a stock you have limited downside and unlimited upside, while it’s the opposite for short: limited upside and unlimited downside because the share price theoretically can rise endlessly. By going long your downside is a maximum of 100%, and quite unlikely to happen, while the upside for short selling is 100% and not likely to happen (assuming no leverage). This fact skews the probability of tails and makes short-selling very difficult to perform profitably.

What is a short sale?

By selling short you are selling something you don’t own. In the derivatives market, this is no problem: you simply sell a contract that you believe will go down in price, thus creating a “deficit”. This is a 100% zero-sum game: what the buyer gains or loses, equals the loss or gain to the short seller.

Going short a stock is more difficult because you can’t sell something you don’t own: the number of outstanding shares is given. This is how it works:

Investor A owns 1 000 shares in stock ABC. He is a long-term shareholder but would like to get an additional income by lending his shares to short-sellers. Investor B believes the share price of company ABC will drop, and thus wants to sell 1 000 shares short in the market. By looking at the website of his broker he finds out he can borrow 1 000 shares at 5% annual interest. When he borrows 1 000 shares from the broker (and the broker borrows from investor A) he can sell them in the market at 75 dollars, hence being “short” 1 000 shares. If the share price drops to 70, he can buy them back at and pocket a profit of five dollars per share (5 000). If the stock goes up and he buys them back at 100, he loses 25 000.

What happens if the stock pays a dividend? The investor being short receives the dividend but is of course obliged to give it to investor A.

Who gets the interest paid by the short seller? It depends on the broker.

Shorting stocks is a bet against the tide

In Triumph of The Optimists by Dimson, Marsh and Staunton the authors concluded that the upward drift in the stock market over the last 101 years was about 9% per year. By being short you are betting against inflation and corporate profits, and perhaps even multiple expansion. Why bet against this? Adding the costs of borrowing and it gets pretty evident the cards are stacked against short sellers unless you are a speculator of extraordinary abilities.

Fuel to the fire

One of the main reasons we see parabolic moves is due to short-sellers covering their positions (by buying). The buying is in addition to other buyers, and thus short-covering adds fuel to the fire. Furthermore, brokers tend to demand more collateral at such times, again exacerbating the rise if short-sellers cover at the same time. And, as illustrated in the quote by Niederhoffer that started this article, short-sellers give in at the same time when they can’t take the pain any longer. It’s a vicious cycle.

Short as a hedge?

Many hedge funds and traders use short positions to hedge market neutral strategies, to adjust for long/short exposure, or to simply hedge long positions temporarily.

My experience from daytrading taught me that shorting is a bad hedge because stocks in the same industry often go their separate ways in any time frame. For example, I used one strategy to buy/short SPY to “hedge” my portfolio. It turned out to be a very lousy hedge. The stock market consists of many industries and stocks, and they all do different things every day completely independently from each other. My hedge turned out to make things worse. Warren Buffett used to hedge his positions in his early career to provide downside protection, but he has admitted this strategy was not very successful.

In my daytrading I made more money on the long side than on the short side, even during the GFC in 2008/09. Actually, the long side performed better than during a bull market. How is this possible?

The main reason is the force and velocity of the decline compared to the rise. Stocks decline rapidly, but rise gradually:

The anatomy of the stock market

Bearish periods are quite frequent, but they last much shorter than bul