Short selling (also known as shorting or going short) is the practice of selling shares that have been borrowed from a broker with the intention of buying these shares back at a later date to return to the broker. In less technical terms: a short-seller is betting on a stock price to go down.
As you very well know, the days of ever-increasing stock prices have long passed and numerous investors now ask themselves: “how can I make money in the stock market if prices don’t go up?
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A possible answer could lie in the business of shorting stocks. Let’s take a close look at the pros and cons.
First and foremost, investors should generally be wary of shorting stocks. In fact, while a stock can only go to zero (resulting in a loss of 100%, if you bought the stock), there is no rule that keeps stocks from rising into galactic spheres. Therefore, the losses of a short-seller can theoretically even exceed his or her principal investment!
Secondly, a rising stock becomes a bigger and bigger position in your portfolio. This can be great if you bought the stock but it certainly is a nightmare when you are short! Vice versa, a winning short continuously become a smaller portion of your account and hence contributes less and less to your portfolio return. This effect makes shorting relatively costly, since you are required to re-adjust your position sizes a lot. As to quote David Einhorn (an investor who has made an investing fortune by going long and short in stocks) from his Q4/2008 investors’ letter: “Though VOW was not a large position on Friday, it became one by Tuesday.” He refers to Volkswagen St. (symbol “VOW”), a stock that was involved in a very major run-up in the fall of 2008. This steep increase was driven by a so-called short-squeeze, a buying rush by short-sellers who have to cover their shorted stock as it becomes too big of a trade in a portfolio. As a short-seller, a short-squeeze can wipe you out rather easily.
Thirdly, shorting looks nice on paper but not all the stocks you want to short are also available! Obviously, shorting crappy companies could be very profitable but somebody has to lend them to you! In addition, this somebody is probably going to charge you a very decent fee for lending you the shares.
Given that you now know three intriguing reasons why not to short, why bother about it?
Well, think about it: benefitting from falling stock prices would in fact be quite a treat!
Imagine you are a decent stock investor and you can drive home a 5% excess return (over a benchmark like the STOXX 600) per year. If the stock market does not go up ever again (just imagine!) you will make 5% a year because you select stocks so well. Now think about what happens if you shorted an equal amount of stocks as you have bought stocks- a trade that would make you “market neutral”. Given that you can also generate 5% excess return by shorting stocks, your portfolio return would end up being 10%! Even better: you took out market volatility from your portfolio since a market neutral exposure means that you have detached your portfolio volatility from the market volatility. We see that if you do it correctly, shorting can add value to your portfolio.
The practical answer pro/con shorting in a portfolio seems to boil down to a trade-off between theory and practicability. Most importantly though, if you are the very risk-averse type, shorting should not be among your investment instruments. Just don’t take the risk. Additionally, if you do not appreciate following your trades on a daily basis, shorting is not for you. Leaving a short unobserved for several trades can wipe you out, so better watch out.
A sophisticated and active investor might consider adding some shorting skill to his or her weapons tough, as it brings to the game a very effective tool for tackling market swings and hedge volatility.