Why I do not like shorting stocks

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When you buy shares of a company, you hope that the value of the shares will rise in a short or long period of time, or at least that it will provide dividend. When you “go long,” the maximum possible loss is 100% (your invested capital) which can happen if the company you bought were to go bankrupt.

Shorting, or short selling, is when an investor borrows shares and immediately sells them in hopes that he or she can buy it for a lower price before returning it to the lender and gain money from the difference.

I remember the first time I heard about shorting stocks. I was watching the James Bond movie Casino Royale. I was only 10 years old at the time and I did not fully understand what happened until I watched the movie again years after. The villain Le Chiffre shorts the shares of the aircraft producer, Skyfleet, and plans to blow up the new airplane they are introducing, which would greatly decrease its share price. Thankfully, James Bond stops him and the stock price continues to go up even more, and Le Chiffre loses money on the risky bet. This is the simple explanation of Le Chiffre’s plan, but it was in fact a financial instrument called “put option” he bought which had a “strike price” at a lower price. If you are interested, you can read more about it here.

The fundamental problem with short selling is the chance for unlimited losses. There is no limit to how much money you can lose if the shares rise. Also, instead of having a potential gain which has no limit when you buy long, you choose to have a limited gain of 100%. If you purchase a stock at €100, the most you can is lose €100, but the stock can also rise to €500 or even €1000. With short selling it is the exact opposite. The most you can ever make from a short sale on a €100 stock, is €100. If the price would rise to €1000 you will have to pay that amount back to the lender to close the position.

There are of course some horror stories when shorting has gone wrong. Joe Campbell decided to place a $37,000 short position on KaloBios Pharmaceuticals Inc. on November 2015. The day after a friend called and let him know that shares had gone up by 800% in just one day and he now had with a debt of $106,445.56 on his brokerage account. He actually had most of his money in just this micro-cap and decided to create a GoFundMe page in hopes that he would receive sympathy from people to cover up his losses. It resulted in some backlash from people as he was being greedy with his risky bet, but he did in the end receive $5310 in donations.

On the Swedish stock market there was a New York based hedge fund who shorted up to 2% of the stocks of a very hyped high tech company called Fingerprint Cards. It did, unluckily for the hedge fund, continue to increase in price and became the fastest growing company in Europe in 2015, with a stock price increase of almost 1700% in a year. Even though the stock price have gone down quite a lot since its all time high, the hedge fund must have lost a substantial amount of money.

People usually say that this kind of practice should be left to very experienced investors, due to the theoretical imbalance. I would, however, take caution investing in funds or companies that short sell, or at least very rarely do so. An example which I like to bring up are hedge funds who claim they are not exposed to the stock market. They undertake the strategy to be “market neutral,” which means that they go long with 50% of the stocks in their portfolio, but also 50% short. They seek to profit from both increasing and decreasing prices in a particular industry, or in the broader market. I would argue that they instead have a double exposure to the stock market as even if the stock market, or the industry, would be in a downward spiral, your shorted stocks might go against the trend and you could therefore lose even more.

I personally think investing in stocks is risky enough and short-selling is usually a short term strategy with a timespan of less than a year, which I do not like. I will soon write a blog post to try to outline my current investment philosophy and how I still buy stocks even as a student.

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