Why is Short Selling a Dangerous Financial Strategy?

The term short selling is often seen in the news. This tactic is regularly used by well-known investors. They are also very public about the shares they have shorted. This prompts many retail investors to follow suit. While, it may be true that many funds and high net worth investors make a lot of money shorting stocks, it is also true that short selling is dangerous. Generally, it should be avoided by retail investors. In this article, we will have a closer look at the concept of short selling. We will also try to understand the common risks that are associated with short selling.

What is Short Selling?

Every stock transaction is made up of two trades. There is a party on the buy side of the trade, and then there is a party on the sell side of the trade. Usually, buy and sell take place in chronological orders. This means that a party first has to buy the stock before they hold it for some time and then sell it.

However, this is not necessary. In the share market, it is also possible to sell first and then buy later. These transactions are called short trades. When a trader decides to go short, they borrow the stock from a broker-dealer and then sell it. Later, they hope that the price of the stock will fall. Once, the price does fall, they buy it back from the market and give it back to the broker-dealer. Hence, a short trade is the opposite of going long. When an investor is going long on a trade, they are hoping that the price of the underlying security will rise. On the other hand, when they are going short on a trade, they are hoping that the price of the underlying security will fall. Hence, short selling is a way to make money when the markets are in decline.

The following reasons make short selling an extremely risky proposition:

Unlimited Downside

When an investor goes long, they can lose a maximum of 100% of their investment. This is because the value of their investment could turn to zero if the company faces bankruptcy. However, when investors go short on an investment, the potential losses are unlimited. This is because there is no limit to the magnitude of rise that a stock may witness. If the stock rises 200% when an investor is expecting it to fall, they may end up losing twice as much money as they had invested!

Margin Calls

When an investor goes short on a stock, they tend to face margin calls if the value of the stock fluctuates in the opposite direction. When these margin calls are received, investors are supposed to deposit more cash with the broker so that the position is continued. If this additional cash is not deposited, the broker will square off the position without the investor’s consent. Because of these constant margin calls, short selling can only be done by active investors, i.e. people who have the time and the inclination to monitor price movements and make decisions. Retail investors are usually passive investors. This means that they do not have the time to think about these decisions in the middle of the day. This is the reason why short selling is not suitable for them.

Extra Costs

Another major problem with short selling is that there are several costs associated with transactions.

Firstly, the transaction is dependent upon the ability of the broker-dealer to find a party who is willing to lend the stock. Obviously, the broker-dealer does not do this for free.

A hefty commission is charged by intermediaries for this service. Also, the investor owes money to people in the market. This is because they have borrowed the stock. However, they have made no payment to the lender. When they eventually pay off the lender, they also have to pay interest.

Depending upon the stock being traded, this interest cost could add up to become a significant component. The interest cost prohibits investors from holding the short position for a long period of time. Since most short positions are squared off in the short term, these trades are usually speculative in nature. Hence, the retail investor should ideally stay away from these trades.

Buy-In and Short Squeeze

Short trades are inherently unstable. This is because investors have very little control over the stock that is being traded. For instance, it is possible that the lender of the stock may suddenly demand it back even though you are willing to pay interest on the stock. This is known as a buy-in.

These situations force the short sellers to liquidate their positions and pay back the lender. Similarly, other parties could refuse to sell you the stock even though you are willing to pay a fair price.

In such a situation, you will not be able to buy the stock back and return it to the lender. This situation is known as a short squeeze. It is known to take the prices higher within a short span of time. This is because all short sellers rush to cover their positions resulting in excessive demand.

To sum it up, short selling is speculative and short-term in nature. This makes it an inherently dangerous strategy which investors are better off avoiding.