It might be tempting to short the market or a stock but before doing that, one must understand the risks. In this part of my article series on how to short stocks, I’ll show you why most people shouldn’t short and what the dangers are of doing so.
When You’re Short On Time & Nature Is Working Against You
Buffett always says that the average investor should invest in stocks over a long period of time and that he or she will do fine by doing so. Why is he so sure about that? He is sure about that because through time, there will be dividends coming and the economy will grow.
Further, there is no cost to owning stocks and even if they crash at some point in time, you can reinvest the dividends and buy more on the cheap to do even better over time. When you are long, time, the economy, the nature of human growth, reinvesting, and dividends are all at your side. When you are short, time is against you because it costs to be short and nature is against you because corporations and economies grow.
There’s Huge Cost To Going Short & Unlimited Risks
If you buy a put option and the stock price doesn’t decline before the put option expires, you lose all your money.
If you go short by borrowing a stock first, then selling it on the market with the intention to buy it at a lower price, you first have to pay the borrowing cost and then if the stock price appreciates, you have to buy it at a much higher price. As the upside is unlimited to how much a stock can appreciate, your risk when going short is 100% when buying options or unlimited when going plain short.
If a short squeeze happens, you might lose your shirt and then some. A short squeeze is when there aren’t enough shares to cover for the shorts’ positions. As they are forced to cover due to a rising stock price, the actual stock price can go sky-high.
One of the best examples of a short squeeze the 2008 Volkswagen case. In 2008, Porsche owned 31% of Volkswagen and the state of Lower Saxony held 20%. On October 26, 2008, Porsche revealed that the company increased its stake to 43% plus that it had options to increase it to 74%. In the meantime, 13% of the company was sold short and another 6% was owned by index funds. When you add things up, 74% owned or controlled by Porsche, 20% owned by Lower Saxony and 13% short makes 107% of the company, making it extremely difficult for short sellers to cover their position.
If the stock you are shorting pays a dividend, you are responsible to pay that dividend to the person that has lent you the stock.
The Key With Going Short Is To Predict Short Term Market Moves
I’ve mentioned a few times how timing the market is extremely difficult. Therefore, going short is extremely difficult.
In a recent article on Stanley Druckenmiller, I wrote how he missed most of his trades and macro bets in 2017 and that his returns for 2017 will probably be only in the single digits. So when you go short, the key is to make it in such a way that even if your timing is wrong, you don’t go belly up. A lot of knowledge is required to do both things, time the market and analyze the risks.
Going Against Central Banks
The intention of the huge amounts of money printing in the last decade was to increase asset values so that people felt more confident about spending money. So much of the global economy relies on stock markets and asset values that going short means going against central banks which can print money, buy corporate bonds—like the ECB is still doing—or even buy stocks, just like the Bank of Japan is still doing.
Further, when politicians become focused on the stock market (Trump has tweeted more than 60 times about stocks) it might be dangerous to bet against those who have the power to change laws and even buy stocks or bail out companies if necessary.
You Have To Put Up Some Collateral & Buy In
Now, no broker nor bank is going to lend you shares without it being certain that you can repay them whatever happens. Perhaps the stock price jumps up just as you’ve shorted it, the broker can give you a margin call and force you to close your position even if the stock drops like a rock the next day.
If the broker can’t find available shares for shorting, you might be forced to cover your short just because the lender pulled his shares and there are no other lenders.
It Takes A Lot Of Time & Nerves Of Steel
Shorting is something that is mentally exhausting as you need to analyze a lot of data and constantly be on the watch for new information, and also keep an eye on market sentiment. On the other hand, the person long stocks doesn’t have to do more than look outside the window and see whether people are driving their car. If they are, Exxon will probably pay dividends for another year.
If I haven’t convinced you that shorting isn’t for you, my next article will be about the cost of going short and how to short a stock by using put options with some examples on not so great trades even if they might have looked like great trades.