How to Ruin Your Investment Portfolio (Part III: Short Selling)
- By : Menard
- Category : Investing
- Tags: How-Not-To, Short Selling
In Part II of this blog series, I wrote about how technical analysis is mostly nonsense. This post talks about why you should avoid short selling.
In Wall Street and beyond, there is no shortage of greedy people. Many will resort to strategies that are borderline immoral like short-selling stocks of company XYZ and wishing that the company loses half of its value so long as they profit from the trade— even if it meant that the company goes bankrupt and the majority of its employees are laid off.
Never mind that the strategy can backfire like a cannon that’s projected directly upwards. Hare-like investors believe that the best way to build wealth is to use leverage— using other people’s money without regard to the nature and extent of the risk. For them, making money at a tortoise-like phase is boringly slow.
And they’re the type of people who would eat a marshmallow on the table without hesitation— delaying gratification is never in their vocabulary. After all, the greater the risk, the higher (and faster) the potential reward.
What the heck is short selling?
The financial world, like any industry, is full of jargon. The terms long and short are the two that had me scratching
Having a “long” position in Tesla (TSLA) stock means that you own the shares. Investors maintain a long position with the expectation that the stock will rise in value in the future. Perhaps because you equate drivers of cars with internal combustion engines to cigarette smokers, or you simply believe oil prices will skyrocket.
On the other hand, a “short” position in the same stock means you’ve sold some shares that you don’t own. This means that you borrowed them from your broker hoping that the shares decline in value. You need to establish a margin account with your broker for this. Meanwhile, you pay interest until you can cover the short position, i.e., buying the shares back.
Note that besides stocks, you can short-sell other tradable securities including forex, broad market ETFs, and even mortgage securities. Billionaire George Soros is famous for “breaking the Bank of England” by shorting the British Pound, for example. Many hedge-fund managers short sell because it enables them to profit in both bull and bear markets.
You profit when the stock price drops
To profit from the short-sale, the stock price has to plummet in value. That way, you can buy the shares back at a much lower price than what you initially sold it for— enough to cover the amount you borrowed plus interest.
When you borrowed $1,000 to buy 100 shares and covered the same shares for $500 in total because the stock price declined by 50%, your net profit would be $500. And you didn’t even have to lay out any money to do the trade.
So far, so good. But here’s where it gets ugly.
You lose if the stock price rises
The risks in selling short occur when the price of the stock goes up— not down— or when the drop in price takes a substantial length of time. The timing is important because you are paying interest, which we don’t even show here.
In this example, the stock price suddenly rises by 50% to $15. So it will cost more for you to cover the original position.
We are dealing with relatively small numbers here, so you probably don’t feel the risk.
But keep in mind that when you are in a short position…
There’s no limit to how much money you can lose if shares rise
When you enter in a long position, your maximum possible loss is 100% of your entire initial investment. That can happen if the company goes bankrupt, for example.
A short position, however, is a different beast. If the share price increases soon after you place a short position, you could quickly cover by buying back the shares and return them to your broker.
That is if you’re lucky!
In 2015, one trader woke up with over $106,000 in debt after one pharma stock (KBIO) skyrocket overnight because of some notable development in the company. He had $37,000 in his E-Trade account.
Not sure if he ended up liquidating his and wifey’s 401Ks. But he did start an humiliating GoFundMe account.
inherently immoral with short selling?
There’s nothing inherently wrong with short-selling. In fact, short-sellers help provide liquidity to the market, and at the same time help restrain other investors from chasing over-hyped stocks in times where tech stocks sell at ridiculous valuations, for example.
If you’re morally upright, try short-selling tobacco, marijuana, or gun manufacturers as much as you like.
As long as you do not become one of those greedy son-of-a-bitches who manipulate the prices by spreading false news in the market place, you’re fine.
However, keep in mind that it’s something that you’ll never EVER need to build lasting wealth. Don’t let your financially impotent neighbor, friend, or relative convince you otherwise.