Why Shorting is Dangerous

Shorting a stock seems straight forward.

If you see a bad company with impending competition, an overvalued stock, a corporation with large annual losses with seemingly no prospects to turn it around, or a company where the CEO just plunders by awarding big bonuses to himself and empire-builds and doesn’t return excess capital back to shareholders, it seems like shorting might be a good idea. To the contrary,

Shorting anything, even bad companies is dangerous. 

Plenty of brilliant investors have lost a lot of money shorting or investing in things that were ‘sure things’. Due to the dynamics of a trade, shorting can cause a lot of short pain for a variety of reasons. Here are five:

The Five Reasons Why Shorting is Dangerous, Potentially Leading to Short Squeezes

Unexpected M&A

Although a company’s stock is overvalued, another company might buy it for a big premium causing a lot of short pain. Case and point, Straight Path Communications at one point was a $400 million market cap company that short sellers thought wasn’t a good bet. Then a bidding war emerged, and the company was sold to Verizon Communications Inc.(NYSE:VZ) for more than $3 billion or a 437% premium. As crazy as that is, there are even higher premiums — Allergan Plc for example, shelled out a 498% premium for Tobira Therapeutics in prior years.

Growing into the Valuation

Good companies that seem overvalued can grow into their valuation. At some point, Facebook Inc (NASDAQ:FB) seemed overvalued and like a good short. A logical investor would have thought around the time of Facebook’s IPO that the social network wasn’t adjusting to mobile well, and that Google might come around and kill it. Due to that sentiment, many thought Facebook was overvalued and the stock fell sharply from its IPO price. Unfortunately for shorters, Facebook eventually adjusted to mobile and also bought Instagram and Whatsapp, two apps that are arguably mobile first. Google also failed to destroy Facebook, although obviously the company still has a shot down the road if there are platform changes. Facebook’s current price is now multiples of its IPO price and shorts have lost a lot of money.

Promotional Management

Even if a CEO of a company doesn’t put shareholders first, the executive could potentially run an awareness campaign with promoters and cause the company’s stock to go up for a few days/weeks/months and squeeze shorts in the process, especially if the float is small. So high short interest, low float, and unexpected news or promotional management can cause stocks to behave in ways that could cause short pain at least briefly. If a float is small, it is easier to send the stock up higher if there is enough buying.

Unexpected News That Could Cause Short Pain

Prices can go up due to unexpected news. During the Great Recession, for example, many investors were short Volkswagen because the company was overvalued versus its peers, whose stock fell sharply and Volkswagen’s stock didn’t fall as far. Then unexpected news with Porsche and options occurred in late October 2008, and VW was briefly the largest company in the world by market cap for a few days. Shorts felt a lot of pain and were forced to cover at very high prices.

The Stock Market isn’t Rational All the Time

Stock prices are set by supply and demand, and in the short term could be dictated by sentiment, technical, and other non-fundamental factors. Just because a company is losing money and is fundamentally a bad bet doesn’t mean its stock won’t go up in the short term. The stock is worth whatever people want to pay for it, and sometimes people are irrational — just like the market. Shorters should not expect the market to be rational all the time.

Conclusion – Don’t short if you don’t have the skill, mental toughness, or experience

Even the best of the best have a hard time making money shorting. Read any Market Wizard books such as Market Wizards, Updated: Interviews With Top Traders or By Jack D. Schwager: Market Wizards: Interviews with Top Traders and you’ll come to that conclusion. George Soros may have made a ton of money shorting the British Pound, but a ton of other brilliant investors have also lost money shorting things.

With that said, investors should also try and use fundamentals at all times. Although shorting is dangerous, owning shares of bad companies for the long term could also be painful — that is for another blog entry, however. Until then, best of luck.

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Disclosure: No Positions

 

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