Think twice before you try short selling.
Most long-term investors attempt to make money in the stock market by identifying individual stocks or exchange-traded funds that they believe will rise in value over time. However, certain investors actually profit off bets that share prices will go down, not up. These bets are called short sales. Short selling involves borrowing shares of a stock from a broker, selling them at market price and then buying back the shares at a lower price on a later date. While short selling can be advantageous at times, there are plenty of reasons the average investor should think twice about short selling on a regular basis.
There are unlimited losses.
When a typical investor buys shares of a stock, the absolute worst-case scenario is that the company goes bankrupt and the stock’s share price goes to zero. For the investor, that scenario means a 100 percent loss. At the same time, potential gains are unlimited because there is no cap on how high a stock’s share price can climb over time. But for short selling, the risk and reward skew is reversed. Potential gains for a short seller are capped at 100 percent, while potential losses are unlimited.
You have borrowing fees.
Like many things on Wall Street, borrowing shares of stock isn’t free. Short sellers must pay brokers a borrowing fee. Unfortunately, some of the most popular stocks among short sellers have some of the highest borrowing fees. Like the rest of the market, borrowing fees fluctuate based on supply and demand, and the fees associated with some of the most heavily shorted stocks can approach 100 percent of the value of the trade on an annualized basis. These borrowing fees mean short sellers are already starting out in the hole as soon as they take a position.
It’s ‘icky’ to bet against the market.
Outside of the dollars-and-cents arguments against short selling, some investors have a philosophical problem with short selling as well. NYSE Group president Tom Farley says it “feels kind of icky and un-American betting against a company.” Short sellers played a huge role in the volatile declines of U.S. bank stocks in 2008 that threatened the stability of the entire American financial system. While short sellers argue that the practice is an important part of stock valuation in a healthy free market, others say that betting against companies or the U.S. stock market simply rubs them the wrong way.
You must pay interest.
Short sellers are required by law to have margin accounts, and margin doesn’t come free of charge. Investing on margin is like taking out a loan from a broker to buy (or borrow) stocks. Much like a bank loan, investors must pay interest on their margin. The longer a short position remains open, the more margin interest accrues. Over time, fees and interest can make it difficult for short sellers to turn a profit.
You pay, not earn, a dividend.
Dividends are one of the major perks of owning high-quality stocks in the long term. Today, the average Standard and Poor’s 500 index stock pays a dividend of about 1.9 percent, a payment which is tacked onto any share gains a stock registers each year. Since the shares sold short are only borrowed, the original owner is still entitled to the dividend payments. Paying that dividend is an obligation that falls on the short seller. The higher the dividend a stock pays, the more expensive it can become to sell it short.
You can get squeezed.
A short seller’s worst nightmare is a market phenomenon known as a short squeeze. When a stock has a high short interest, any significant move higher in share price can trigger panic among short sellers. In order for short sellers to close out their positions, they must first buy back the shares they owe. That buying can drive a stock’s share price even higher, enticing even more buying in the market. As the effects of the squeeze compound, share prices can skyrocket in a matter of days or even hours, inflicting huge losses on short sellers.
Short sellers are subject to buy-ins.
Brokers implement safety measures to protect against out-of-control losses in margin accounts. If their paper losses get too severe, margin traders are subject to what’s known as margin calls. Margin calls require traders to either increase their cash balance or close out some of their open positions. If losses get too high, however, short sellers are subject to buy-ins, in which the broker closes out short positions at market price without the account owner’s consent. These buy-ins often occur at the worst possible times, such as the middle of short squeezes, when prices are at their highest.
The trend isn’t a friend.
From a practical standpoint, perhaps the best argument against short selling has nothing to do with fees, risks, short squeezes or interest. One of the biggest advantages long-term investors have enjoyed throughout the decades is the remarkably consistent returns the stock market has generated over time. Since 1926, the rolling 30-year average annual return of the S&P 500 has stayed between about 8 and 15 percent. As the U.S. economy grows, stocks tend to rise. While stock buyers are simply along for the ride, short sellers are swimming against the current by betting on lower prices.
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8 Reasons to Avoid Short Selling Stocks originally appeared on usnews.com
