Shorting stocks has risks that must be known, understood and managed including unique risks of selling short. Those risks are beyond the normal market risks that all investors know and deal with. Investors that know of the many risks short sellers cope with, have a deeper understanding of stock market investing.
What are short selling risks?
Short Story Shorting Stocks course, Lesson 6, answers the question, what are short selling risks? Links at the end guide you to related content if you want to learn more.
What you learn:
You learn of skills, vision and understanding that short sellers must have to be effective. The lesson covers many risks of short selling and provides insight and understanding of the complex options short sellers face. Your stock market vision can improve by knowing the short selling process and the risks they manage. By understanding how and why short selling happens, you can be more aware of both risk and opportunity in stock markets which can improve your investing process.
Shorting stock risks must be known and understood by investors
7 Risks short sellers face on every sale
Short selling has many more than 7 risks, but we start with these big ones:
- The biggest risk of short selling is timing, timing, timing! Get the timing right and make a fortune or get it wrong and lose it all!
- Short sellers must manage unlimited upside price risk against a maximum payoff of a price falling to 0.
- Shorting is expensive with a complex array of costs to manage.
- Shorts stand alone in a contrarian, unpopular strategy.
- Regulator risk – a new regulation that can destroy a play or adds costs.
- Shorts buying back to exit have buy-in price risks on every play.
- Short selling requires discipline and active hands-on management
Shorting stocks has complex risks that investors must know to understand this important force in stock markets. The complications of short selling move that strategy beyond what any beginning investor should consider using. Still this challenging strategy should be known and understood by all investors to know stock markets better.
For their benefit, and to best understand the market, novice investors should know the basics of short selling. This helps a novice understand the effect of shorting activity on the market. Knowing always makes an investor better, more comfortable, more confident and able to invest well.
Shorting stocks is hard because it takes knowledge, experience and the right psychology. The successful short seller has a favorable, strong and resilient psychological makeup.
A very aggressive market strategy
Shorting stocks includes risks such as stirring up management, the market and other investors. Shorting activity usually gets an aggressive response. Shorting starts a serious business on investment fight. Is is not casual play.
To profit and offset all the risks and restrictions, successful short sellers must aggressively play their positions. This is the rough and tough end of the market. Shorting is not for everyone and most certainly not for beginners.
Finding good short targets takes knowledge and experience well beyond that of a beginner. Specific short target selection is also beyond the basics we discuss here. We will stay with some generalizations to give you the flavor, if not the specific techniques, of good short selling.
Selling short is not just the opposite of buying shares long. Selecting short targets requires much more than calculating basic stock valuations. Do not short a stock simply because the price has significantly increased.
Tunnel vision disaster
Investors new to short selling, or any other aggressive strategy, can develop a mental tunnel vision one convinced they have a prime ripe target. That can lead to ignoring other possibilities, or worst yet, market signals you have it wrong. Markets do have a nasty way of testing us when we are convinced we have it right and are smarter than the market.
The stock may simply not cooperate and increase in price. It happens and must be considered as a possibility on each short trade. It can be worse than the situation of someone making money from a rising stock but selling it because it has gone up a lot! Selling winners is the single biggest long investing mistake that I see. And I see it far too often.
Shorting stocks has risks that investors must know including execution risks. You can be making the “right” short bet and still lose money. You must know how to execute well.
Short selling psychological demands
The psychology of shorting stocks is difficult. This demanding strategy taxes the investor mind, emotions and resources. Knowing about more challenging aspects of stock market investing helps you avoid problems, risks and losses. It gives you a better level of understanding stock markets.
Superior performing short sellers are thick-skinned tough and willing to take on man, woman, child, market, company, industry, brokers, you and your mother-in-law!
Psychologically the world opposes the short seller. All are against these predators of the market. Even when the facts should favor the short, plenty of negative stories about them and their ill-founded, unreasonable, illogical and badly researched position will emerge.
Being short is incredibly mentally taxing. It demands much cerebral flexibility and strength. Psychologically shorting is only for people willing and able to stand alone, sometimes for a long time.
All the typical bellowing about short activity is a bit rich. Especially, considering that the only reason any of us are in or even interested in the market has only to do with making money! Going short is a perfectly legitimate but psychologically taxing strategy.
Three best short characteristics
Stocks that rank among the greatest short sale candidates have one or more of the following characteristics:
1. Accounting Issues
Fraud is the very best news for a short seller. In other cases, shorts can simply attack a company that has bad management or poor financial controls. Even if correct about bad numbers, shorts are always challenged to get the timing right.
2. Obsolete Product or Service
Obsolescence can take forever! And that is often very much longer than you think could be possible. Once the market grasps the facts, playing an obsolescent product or service, makes a great short. Again, getting the timing right remains a challenge.
3. Bad Management
Usually inferior management accompanies either or both accounting and obsolescence issues. At times, ineffective management misses good business situations or opportunities. When the short know this, they can undertake a campaign to convince more investors. Very nasty, expensive battles using many lawyers are a show! Frequently major shorts put together the better business idea, a new management team and try selling it to other shareholders.
Shorts actively manage positions
There is no such thing as taking a passive short position. Shorting stocks has risks that investors must know including execution risks. You can be making the “right” short bet and still lose money. As you know from White Top Investor lessons, change in markets is constant and normal.
Changes mean, when shorting a stock, you must know how to execute well and be prepared to actively manage their positions. Playing short is a very hands on active strategy requiring active management. Shorts get no time off! Advanced topics like the techniques of effectively managing short positions are beyond any basic discussion of shorting and are covered in other lessons.
Management’s counterattack tools
Short sellers must expect a very aggressive counterattack orchestrated by management. Management deploys many weapons without hesitation. Included are:
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- Investor relations
- Public relations
- Media relations
- Lobbying public and private investors/influencers
- News releases including fiction and fluff
- Stock buybacks
- Setting or increasing dividends
- Rising dividends
- Accounting manipulation
- Hyped Numbers
- Earning pumps
- Reporting changes
- Stonewalling
- Insults calling out the reasoning and heritage of shorts!
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Both using and defending against this extensive arsenal gets very complicated and certainly keeps the lawyers busy. To keep our discussion to a basic level requires that we mention these many weapons get used by a plethora of techniques. Shorting stocks has risks including the need to know how to respond to each type of counterattack.
5 dangerous short phenomenon
Shorting stocks has risks that investors must know, including how to cope with these financially dangerous phenomena:
1. Shrinkage
As a shorted stock falls, the short seller must press their position to maximize their return. As the price falls, the position value falls. That means to maximize profits, when they can, more stock gets borrowed and sold as the price falls further.
However, overdoing it by pressing too many shares short, can destroy the opportunity. Overplaying a short position happens. That means when shorting a bad company, that it is actually possible to be too short!
When that happens, covering profitably becomes challenging or even impossible. Covering buying pressure, when too few shares are available, quickly drives prices up consuming all profit. By being too aggressive when shorting, too few shares are left for a profitable exit.
2. Infinite Loss
The opposite occurs when the short play is wrong from the beginning. As the stock price rises the short loss accelerates. It can go to infinity. Best to cover as soon as possible. Ironically. adding the cover buying pressure accelerates the price rise. Losses can rapidly soar.
3. Timing
Always, favorable timing makes all the difference. For example, it can happen that a company has years of bad accounting or reporting errors. Shorting too early guarantees a loss. Or the market may not agree with the short seller, that the product is obsolete or that management is bad. Being too early as a short, gets very costly. Get the timing wrong and nothing else matters. Bad timing means it is not profitable.
4. Crowded shorts
A potential short seller may see a juicy short opportunity. Before proceeding, astute short sellers check that other players are not already carrying a substantial short interest. When many are short, adding further to the short side can quickly become too many. That risks a costly short squeeze or an attracts aggressive bull attention-seeking opportunity when shorts overplay positions.
5. Unforeseen
While not actually a short phenomenon, unrelated, unforeseen and unforeseeable events happen that can go against the short. Massive market rallies completely unrelated to the target company, industry or market can trigger substantial buying that moves against the short.
Shorting stocks has risks that investors must know includes coping with bad karma and losses for unforeseen reasons. It is very challenging to consistently perform well as a short seller.
Interest rates do change
Changing interest rates are included the ‘Unforeseen’ risk because interest rate changes can be a significant cost factor and, most often, rate changes are unforeseen by short sellers.
More and unique short seller risks
As if there are not already enough risk to cope with, short sellers also must deal with several risks unique to short selling. We begin covering those risks by considering the source of the stock that must be borrowed. To sell short we need to find stock to borrow which in itself can be a challenge.
Hard to borrow stock
Short players must be aware of potential issues around hard to borrow stock. When brokers have clients holding large amounts of the stock being considered for a short, the supply of stock is said to be easy to borrow. If there are few clients holding the stock or the totals held are smaller amounts, the stock is hard to borrow.
In the case of hard to borrow stock, the broker charges more in the form of a daily fee reflecting the price and availability of the stock. The “hard to borrow fee” is one more issue and cost a short seller must know before taking a short position.
Lender wants to sell
When brokers lend short sellers stock to sell, the stock owner is not informed but retains ownership including rights to dividends or to sell at any time. Should the stock owner sell and the broker has other client inventory to loan the short, no problem. The arrangement continues.
However, if there are few other stockholders or limited investors the broker will charge a “hard to borrow” fee and carry on as before, but with the addition of higher cost. On the other hand, if other inventory is not available, the broker will force the short to cover and pay back the borrowed stock. That could get bad, or to be more accurate, expensive!
Such an outcome forces the short seller off the play and let the chips fall where they may! All costs go to the short seller. This could be a situation that you are right, the stock is going down, but being forced off the short turns it into a losing investment move.
Dreaded margin call
Margin calls can come with no notice and completely destroy the short trade and if forced to sell in unfavorable circumstances, can inflict severe portfolio damage.
Short selling risk management
Investors will find that risk management opportunities for shorts are limited and expensive. When prices move against a short position, it gets ugly and costly fast! There are few lifelines. However, there are a couple of possibilities.
Buy stop orders are the first line of risk management defense for short sellers. That order triggers a market order to buy back the stock when the stock trades at or above the stop price.
A more sophisticated order, the trailing buy stop can place more complex order conditions. Explaining these orders in detail could easily develop into a full lesson. It is enough to say stops are no sure thing or a guaranteed exit.
The very best defense for shorts is to be right and relentlessly watch your positions. When you are wrong, or the market goes strongly against you, get out as fast as you can to preserve as much capital as possible.
Market risks of going short
As in any trade or investment, short selling has market risk. That means the price of the stock may move the ‘wrong’ way. In the case of a short seller higher prices hurt.
Short selling is a margin play. That means the short seller carries the liability that comes with borrowing an asset. In the case of a short seller, stock no capital gets borrowed.
As when carrying any liability, time costs money. In the case of borrowing stock, the costs to carry the loan can tip the balance for or against the short seller. A profitable trade can lose money due to costs.
Should the stock price move against the short seller, those losses can rapidly multiply. Such adverse price movement can quickly produce very significant and, in theory, unlimited losses.
Still more short seller risks
In addition to any market risks, short sellers face the risk that the company management may take actions that move stock prices up. Risks of being financially hurt by management’s positive actions are unique to shorting.
For example, declaring a dividend when none existed before, or announcing a dividend increase, can quickly move a stock price up. Such news announcements usually bring a wave of share buying by investors attracted to the dividend.
Such buying pressure can give a stock price strength and most likely pushes the price higher. Sometimes, sharply higher. Exactly what the short seller does not want to happen.
As well, other announcements can hurt, such as new unexpected business or even simply negotiations for a major new business contract. Also, announcements of new products, markets, segments or regions can put company shares in play.
Any company announcing major new business often puts the shares in play and moving higher. In large or small companies, very significant share price movement may result. Such price movements can quickly hurt a short seller.
Strategic review risk
A company struggling with business challenges or under pressure by substantial short selling may announce a ‘strategic review’. That is corporate speak or market jargon meaning the company is for sale. This is certainly one of the unique risks of short selling.
Hanging a “For Sale” sign on a public company certainly attracts attention. In addition to any prospective new controlling or ownership group, such announcements most often attract both investors and speculative interest.
A buying frenzy can result. When it does, there is only one way for the stock price to move. Up! That quickly leaves any short seller, that did not cover, drowning in losses!
Media and news release risks
At times company management and short sellers engage in media battles called dueling news releases. Management news releases point out all the positives and why the company is, or will soon be, doing well.
Short sellers do not always respond with news releases but certainly do respond by freely expressing a negative view of management and the company. Any news releases that do come from short sellers naturally point out what a disaster management has been or why prospects are so dim under the current management.
Company management often feels very deeply and personally motivated; after all, their jobs are certainly on the line! They will consider many actions or announcements to make life miserable, or at least unprofitable for a short seller.
The media loves this stuff! Drama in business or boardroom battles always gets top billing and opens doors for interviews. The court of investor opinion matters because they vote by buying or selling shares in the company.
At times, such battles are as entertaining as any infotainment program available. At times, some combination of bluff, poker and truth or dare get played in rooms, or is it minds, filled with smoke and mirrors! This is the most bizarre of the unique risks of short selling.
Or, could it be you are late getting the news or information? Perhaps what you think the market does not know, has already been priced in. The market may have already digested the news.
Dividend costs add up
Dividend costs are present risks as dividend costs can change. Two changes can happen, either the dividend gets increased or the timing of the short trade is significantly off.
Should the board raise the dividend, costs immediately spike for a short seller! Should the short trade timing be off and the position has to be carried longer than planned, the short seller must possibly cover multiple dividend payments.
In either case, costs escalate. Costs or share price increases have a huge negative financial impact on the short. The short seller has to get it right.
Calendar game risks
The calendar risk can surprise a short. Corporate boards set dividend amounts and dates. It is within their power to change either the dividend amount or date, or both. Naturally, because they can, they do.
The owner of a stock, at the market closing, the trading day before the ex-date, is due any dividend. The ex-date is the first day of a new (future) dividend period.
Buying a stock on the ex-date means the new owner does not receive the previously declared, but not yet paid dividends. The payment delay or real payment of the dividend may happen a few days later. Paying two weeks after the ex-date is a common occurrence.
Here is a nasty bit of gamesmanship. Boards can move the ex-date up the calendar forcing earlier payment of dividends. That can substantially increase the short seller’s costs.
Shorts will certainly call foul! They will launch lawsuits and keep a bunch of lawyers busy as will the company!
Warrant and spinoff risk
The nastier of the unique risks of short selling includes both warrant and spinoff risks. Management can issue warrants to all shareholders. They can sell, disperse or change major parts of the company targeted by the short seller.
That can mean selling assets or divisions or spinning them off to shareholders or to third parties. Making any such moves can vastly change the stock seller values recognized by the market.
It can also move the value away from the short’s position or significantly dilute the ownership value of a share. It can also have the effect of issuing multiple shares in different companies to the same shareholders. That can keep all shareholders happy, except the short seller who sees value melting away.
The word, ‘complicated’ certainly describes the many possibilities. In a flash, the short may find they are now short two or more securities. Suddenly they are holding a far more complex and costly position.
Then, imagine the financial horror if two or more share prices move against the short seller at the same time! When battles get nasty, they get loud. That attracts a crowd.
Share trade volumes very often come alive and the show is on! Bets are made and stock prices can significantly move. Most often up.
Rather than further exploring this complexity and many permutations, the point is, very high risks lurk. Shorting gets complex and carries significant risks. Once you have experience and comfort with markets, you can consider such a strategy. Until then, don’t touch!
The very real short squeeze
When markets move up, even poorly run companies with bad fundamentals can trade at higher prices. Markets, especially in the short term, are not logical or rational. Nutty things such as unjustifiable higher prices can, and do, happen.
A short squeeze happens when short sellers on the wrong side of a rising stock price give in and move to cover. The rising price pressure may even start a buying-panic at the market price in the rush to cover growing losses. That buying can push prices higher, triggering more short covering that again increases buying volume and moving prices higher into an uptrend.
Short squeeze defense
Experienced short sellers avoid short squeezes by avoiding:
- stocks with high short-interest ratios
- companies with small floats
- share that trade low daily volumes
- companies with a bullish sentiment around their stock
- companies with strong advisory support which goes hand in hand with broker support
- markets with an established and continuing uptrend
- shares with any short squeeze history
Trading techniques and skills also avoid short squeezes by:
- disciplined play by following strict rules they set
- consistently using and adjusting stop-loss orders
- taking profits at the first signs of a price turn
Question Answered!
The fast answer to, what are short selling risks, is many! The lesson covers the risks of short selling and provides insight and understanding of the complex options short sellers face. Your stock market vision can improve by knowing the short selling process. By understanding how and why short selling happens makes you aware of both risk and opportunity in stock markets which can improve your investing success.
Lesson takeaways,
Shorting stocks has risks:
Shorting stocks has risks that must be known, understood and managed including unique risks beyond those of a normal market that all investors know and deal with. Investors that know short sellers cope with those many risks, have a deeper understanding of stock markets.
- The psychology of shorting stock is challenging.
- Short selling is among the most aggressive stock market strategies.
- Accounting issues make companies prime short selling targets.
- Obsolete products and services can attract short interests.
- Discovery of bad management practices raises short selling interest.
- Management has many defensive and counterattack tools.
- Short sellers manage shrinking values to avoid overplaying.
- Huge losses can hit short seller that get the play wrong.
- Timing is of prime importance to short sellers.
- Short plays can get crowded and in each other’s way.
- Unforeseen developments can quickly work against short sellers.
- Short sellers depend on borrowing stock.
- Some stock is hard to borrow, some is easy.
- Lender selling can force covering and spoil a short seller’s day!
- Risk management opportunities for shorts are limited and expensive.
- Market risks never go away … the stock may move the wrong way!
- Corrections with 10% price drops happen regularly.
- Dividends may be manipulated or raised to hurt shorts .
- Strategic reviews put shorts at risk by triggering buying.
- Media and news releases can work against short sellers.
- Timing always is a ticking time bomb for short sellers.
- Warrants and spinoff risks may play against short sellers.
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Short story shorting stocks,
Lesson links:
Short selling stock explained Lesson 1
Short selling improves markets Lesson 2
Short selling improves companies Lesson 3
9 Short seller facts align Lesson 4
Making money selling short Lesson 5
Shorting stocks has risks Lesson 6
Who’s selling your stock? Lesson 7
Short seller skill sophistication knowledge Lesson 8
Short seller cost control Lesson 9
Short selling has rules Lesson 10
Next lesson 7:
Who’s selling your stock?
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