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Risks of Short Selling

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6. Short Selling Analytics

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7. Short Selling Alternatives

8. Risks of Short Selling
9. Ethics And The Role Of Short Selling
10. Short Selling Guide: Conclusion

Risks of Short Selling

By
Elvis
Picardo,
CFA
Unlike long transactions (i.e., buying shares or other instruments), short selling involves

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significant costs, in addition to the usual trading commissions that have to be paid on stock

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transactions. These include:

Margin interest Margin interest can be a significant expense when trading stocks on
margin. Since short sales can only be undertaken in margin accounts, the interest
payable on short trades can add up over time, especially if short positions are kept open
over an extended period.
Stock borrowing costs Shares that are difficult to borrow because of high short
interest, limited float, or any other reason have hard-to-borrow
hard-to-borrow fees that can be
quite substantial. This fee is based on an annualized rate that can range from a small
fraction of a percent to more than 100% of the value of the short trade, and is pro-rated
for the number of days that the short trade is open. As the hard-to-borrow rate can
fluctuate substantially from day to day and even on an intra-day basis, the exact dollar
amount of the fee may not be known in advance. The fee is usually assessed by the
broker-dealer to the clients account either at month-end or upon closing of the short
trade, and if it is quite large, can make a big dent in the profitability of a short trade or
exacerbate losses on it.
Dividends and other payments The short seller is responsible for making dividend
payments on the shorted stock to the entity from whom the stock has been borrowed.
The short seller is also on the hook for making payments on account of other events
associated with the shorted stock, such as share splits, spin-offs and bonus share issues,
all of which are unpredictable events.

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Apart from these costs, risks associated with short selling include the following:

Risk of short squeezes and buy-ins A stock with very high short interest may
occasionally surge in pricetypically when a positive development in the stock or broad
market triggers massive short-coveringcreating what is known as a short
short squeeze.
squeeze.
Heavily shorted stocks are also vulnerable to buy-ins, which occurs when a brokerhttp://www.investopedia.com/university/shortselling/shortselling3.asp

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dealer closes out short positions in a difficult-to-borrow stock because its lenders are
demanding it back. The risk of a buy-in is a major risk with short selling because of its
unpredictability and can lead to unexpected losses for the short seller.
Regulatory risks Regulators may sometimes impose bans on short sales in a specific
sector or even in the broad market to avoid panic and unwarranted selling pressure.
Such actions can cause a sudden spike in stock prices, forcing the short seller to cover
short positions at huge losses.
Contrary to long-term market trend As the long-term trend of the market is upward,
short selling is a contrarian strategy. Unlike a buy-and-hold strategy, it has to be
opportunistic and well timed.
Skewed payoff ratio Short selling has a skewed payoff ratio as the maximum gain
which occurs if the shorted stock was to fall to zero is limited, but the maximum loss
is theoretically infinite.

Short selling is a gamble.

History has shown that, in general, stocks have an upward drift. Over the long run, most
stocks appreciate in price. For that matter, even if a company barely improves over the years,
inflation should drive its stock price up somewhat. What this means is that shorting is betting
against the overall direction of the market.
So, if the direction is generally upward, keeping a short position open for a long period can
become very risky. (To learn more, read Stocks Are No.1 and The Stock Market: A Look
Back.)

Losses can be infinite.

When you short sell, your losses can be infinite. A short sale loses when the stock price rises
and a stock is (theoretically, at least) not limited in how high it can go. For example, if you
short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece,
you end up losing $2,500. On the other hand, a stock can't go below 0, so your upside is
limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a
100% gain if a company goes out of business and the stock loses its entire value.
value.

Trading Center

Shorting stocks involves

using borrowed money.
This is known as margin trading.
trading. When short
selling, you open a margin account, which allows
you to borrow money from the brokerage firm
using your investment as collateral. Just as when
you go long on margin, it's easy for losses to get
out of hand because you must meet the minimum
maintenance requirement of 25%. If your account
slips below this, you'll be subject to a margin call,
call,
and you'll be forced to put in more cash or liquidate your position. (We won't cover margin
in detail here, but you can read more in our Margin Trading tutorial.)

Short squeezes can wring the profit out of your

investment.
When stock prices go up short seller losses get higher, as sellers rush to buy the stock to
cover their positions. This rush creates a high demand for the stock quickly driving up the
price even further. This phenomenon is known as a short squeeze.
squeeze. Usually, news in the
market will trigger a short squeeze, but sometimes traders who notice a large number of
shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock
with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.
(To learn more, see Short Squeeze The Last Drop Of Profit From Market Moves.)

Even if you're right, it could be at the wrong time.

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The final and largest complication is being right too soon. Even though a company is
overvalued, it could conceivably take a while to come back down. In the meantime, you are
vulnerable to interest, margin calls and being called away. Academics and traders alike have
tried for years to come up with explanations as to why a stock's market price varies from its
intrinsic value.
value. They have yet to come up with a model that works all the time, and probably
never will.
Take the dotcom bubble
bubble,, for example. Sure, you could have made a killing if you shorted at
the market top in the beginning of 2000, but many believed that stocks were grossly
overvalued even a year earlier. You'd be in the poorhouse now if you had shorted the Nasdaq
in 1999! That's when the Nasdaq was up 86%, although two-thirds of the stocks declined. This
is contrary to the popular belief that pre-1999 valuations more accurately reflected the
Nasdaq. However, it wasn't until three years later, in 2002, that the Nasdaq returned to 1999
levels.
Momentum is a funny thing. Whether in physics or the stock market, it's something you don't
want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you
wouldn't jump in front of a pack of stampeding bulls, don't fight against the trend of a hot
stock.

Next: Ethics And The Role Of Short Selling

6. Short Selling Analytics

7. Short Selling Alternatives
8. Risks of Short Selling
9. Ethics And The Role Of Short Selling
10. Short Selling Guide: Conclusion

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