Do I recommend short selling common stock? No!

This blog has many short ideas involving shorting the common stock of a company.  I don’t actually think that short selling common stock is a good idea.  There are many ways to lose even if you’re right.

The two most important points are as follows:

  1. If your position sizes are too big, there are a number of risk management problems that will cause you to lose money.
  2. If your position sizes are very small, you are wasting your time!

Because I don’t want to blow up, I try to keep my initial short positions to 0.5% or less of my portfolio.  Because the positions are so small, short selling common stock is probably a waste of time for me.  If there are a lot of short ideas on this blog, it is because a large number of them to have a meaningful impact.  I basically need lots of not-so-thoroughly-researched ideas.

Here are the problems with short selling the common:

  1. Illiquidity.  If a position moves against you, you may be forced into a margin call.
  2. Sometimes short squeezes will occur precisely because they aren’t “supposed” to happen.  Volkswagen is a large cap stock in a first world country with a regulated stock market.  Some people thought that it was safe to short it because short squeezes don’t happen with large cap stocks.  They may have also thought that regulators would protect them (haha).  What ultimately happened is that there was a massive short squeeze in Volkswagen stock and German regulators did nothing to protect the shorts.
  3. Your broker may increase the margin requirements on your short positions.
  4. The interest you pay to borrow shares may be extremely expensive.  In some cases the borrow has gone over 100%.  It is very, very difficult to make money when you are paying ridiculous interest rates.
  5. You may get bought-in on your short position.  This has happened to me many, many times.  Sometimes other market participants will intentionally cause these buy-ins to occur.  While the practice is probably illegal because it is market manipulation, it happens in practice.  This is one of the biggest reasons why I don’t like short selling common stock.  This is also how I’ve lost money on stocks that have gone to 0.
  6. The government may implement new regulations that screw over short sellers.  Regulators and politicians do not look favorably upon short sellers.
  7. With hedging, sometimes the hedge will fail because very few hedges are risk-free.  Short selling is no different.  You may have your longs and shorts move against you at the same time.  Whatever forces caused the opportunities to exist in the first place can cause the spread to widen even further.
  8. The returns may not be that good.

Here are risks specific to hedge funds:

  1. If you publicly attacks companies, the company being attacked may launch a costly lawsuit against you.  Even if you win the lawsuit, you still need to pay all your legal fees.  And if you don’t win the lawsuit (e.g. because the judge isn’t that sophisticated and thinks that short selling is evil), it could be a bloodbath.
  2. Attorney generals and other regulators may decide to go after hedge funds (especially short selling hedge funds) because it would improve his/her image in the public.  It looks good for the regulators to take down those dirty, evil short sellers.  These politically-motivated investigations may cause legitimate hedge funds to shut down.
  3. If you are a hedge fund, your broker may leak your positions.  This happened to Copper River and caused the hedge fund to lose huge amounts of money and shut down (read Richard Sauer’s book Selling America Short).

I am very skeptical about long/short hedge funds.  The ones with bad risk management are the ones with too much leverage.  The leverage can cause them to perform unusually well before blowing up.

What about put options?

Put options don’t have these risk management problems.  However, they are complicated and there are significant trading costs.  They’re fine as long as you know what you’re getting yourself into and know what you’re doing.Interestingly enough, even Jim Cramer recommends put options over shorting common stock.  This is because he learned things the hard way.  When he first started his fund, one of his short positions was too large.   Other hedge funds found out and decided to squeeze him, causing him to lose a lot of money.  Then he met one of Michael Steinhart’s employees (who would become his future ex-wife), who explained to him the dirty tricks of Wall Street.  And then Jim Cramer became one of those assholes.  The guy is crazy on TV but maybe he isn’t so crazy after all.

Why am I attracted to short selling?

I think that part of me likes to argue against people and bet against them.  I believe this is perverse and irrational.  I suppose I might be wired in a way where I’m compelled to prove my intellectual superiority over other people (wow, this sounds really f***ed up).

Is my portfolio net long or short?

Long!

Links

Bronte Capital is a long/short hedge fund that I respect.  Their client letters are very interesting and sometimes discuss short selling.

My Motley Fool CAPS page is a stock market simulation where I get to live out my short selling fantasies.

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9 thoughts on “Do I recommend short selling common stock? No!

  1. I’d really like to practice short selling penny stocks in a PRACTICE simulator account. You know, like paper trading with a full simulator, real time market movements, but just with play/pretend money.
    More specifically one that will allow SHORT selling penny stocks. Heaps of trading platforms allow practice trades for long positions, but i’m having trouble finding any that provide a practice account that allows short selling penny stocks.

    Could you recommend any..?
    Thanks so much in advance 🙂

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