Risks of short selling in practice

Short selling is a way of betting on stocks going down.

The normal buy/sell process is reversed.  You sell a stock and hopefully you buy it back at a lower price.  How can you sell something you don’t own?  You have to borrow shares from a broker so that you can sell those shares.

Risks of short selling

  1. Your potential losses are unlimited.  You could use stop orders to cap your losses, but stop orders can knock you out of a trade at a loss only to have that trade go in your favour afterwards.
  2. Crazy stuff can happen.  Volkswagen had an infamous short squeeze where the stock went up over 4 times in the middle of a trading day.
  3. Shorting selling can force your account into a margin call.  During this margin call, your broker can liquidate your profit at awful prices.  They get to collect commissions and they may trade against you.
  4. Other people will try to engineer buy-ins.  There are hedge funds out there who will buy shares in a heavily shorted company.  They will try to drive up the share price, and will yell at an investment bank’s analysts to promote that particular stock (and the investment bank often collects considerable commissions from these hedge funds).  Then they will disallow short sellers from borrowing their shares to short.  The short sellers must give back their shares that they have borrowed, so a buy-in process ensues.  They must buy stock on the open market and return the shares that they borrowed right away… at a significant loss.
  5. For the obviously awful companies out there, you have to pay a lot of interest to borrow shares to short sell them.

If you short ETFs, note that an ETF can trade well above what its assets are actually worth.  This happened to UNG when they said that they would no longer issue creation units (so the risk-free arbitrage on that ETF was no longer available) and the stock traded at a significant premium to its assets, over 10%.  There is some obscure ETF which traded at something like 10X what its assets were worth.

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One thought on “Risks of short selling in practice

  1. Pingback: Short selling shady stocks | Glenn Chan's Random Notes on Investing

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