Most long-term investors attempt to profit from rising stock prices, but that’s not the only way to make a buck in the stock market. Short selling involves borrowing shares of a stock and immediately selling them with the goal of buying them back later at a lower price. Instead of profiting on a rising stock price, short sellers profit when a stock’s price goes down.
[Sign up for stock news with our Invested newsletter.]
Short selling may seem like a straightforward process, but it can be controversial and risky for investors. Whitney Tilson, founder and CEO of Empire Financial Research, recently compiled lists of short selling pros and cons. Here are 10 factors investors should consider before short selling, including five pros and five cons:
Pros:
— Short sellers can make money in any market conditions.
— Successful short trades stand out.
— Short sellers can take on more risk.
— Short selling teaches skepticism.
— Short selling helps investors be opportunistic.
Cons:
— Unlimited downside.
— Short sellers risk a short squeeze.
— Stock loan fees.
— Short selling mistakes compound.
— The market’s long-term trend is the enemy.
Pro: Short Sellers Can Make Money In Any Market Conditions
In general, investors who have only long positions in their portfolio struggle to post gains during periods of market weakness. Investors who have both short and long positions have opportunities to profit even during recessions or stock market crashes. For example, when the stock market crashed during the 2008 global financial crisis, Greenlight Capital’s David Einhorn made a killing on his short position in Lehman Brothers, which famously succumbed to bankruptcy. Skilled short sellers don’t have to wait for the tide to shift during a market downturn and can profit both on the way down and on the way back up if they time their trades correctly.
Pro: Successful Short Trades Stand Out
Because the average investor has mostly long positions, Tilson says a winning short trade often helps investors or money managers stand out in the crowd. “That is what we did early in our careers in 1999-2000, nailing the internet bubble, and then again in 2008 with the housing bubble, which led to an appearance on ’60 Minutes,'” Tilson says. In fact, several popular fund managers earned reputations as Wall Street gurus thanks to short selling. George Soros famously made $1 billion shorting the British pound, Jim Chanos earned big profits shorting Enron and Michael Burry made large short bets against the U.S. mortgage market that paid off big in 2008 and 2009.
Pro: Short Sellers Can Take On More Risk
Short sellers can invest more aggressively on the long side because short positions are like insurance against downturns in long positions. Tilson says short positions are like homeowners insurance, and they can give investors peace of mind about their long positions. He says he would never be comfortable taking his fund’s long exposure up to 100% at times if it were not for his short positions. In addition, he held onto winning long positions in high-beta stocks like Netflix Inc. (ticker: NFLX) for longer and made more profits on the positions because he simultaneously held short positions in similarly volatile stocks.
Pro: Short Selling Teaches Skepticism
Tilson says the short selling skill set is valuable for investors even if they do little or no actual short selling. “Having the mindset of a short seller is very valuable: It helps to develop healthy skepticism, know where to look for bombs on a balance sheet and be able to identify value traps,” Tilson says. A trader doesn’t have to short sell to benefit from identifying and potentially avoiding stocks that are at risk of trading lower. Information investors get directly from a company or from other investors is often biased, and a healthy skepticism can help investors put that information in its proper context.
Pro: Short Selling Helps Investors Be Opportunistic
Baron Rothschild is credited with the age-old contrarian investing adage “the time to buy is when there’s blood in the streets.” Unfortunately, many investors have the least amount of portfolio flexibility during these periods of cyclical market downturns when the long-term buying opportunities are greatest. Tilson says short selling can create opportunities for investors to take advantage of market downturns. Short positions help provide cash and confidence to buy aggressively during severe market declines when most investors are fearful, such as during the financial crisis in 2008 or the COVID-19 pandemic in 2020. These periods of heightened fear often make the best long-term entry points for long positions.
[SEE: High-Risk Stocks for Aggressive Investors.]
Con: Unlimited Downside
If you buy a stock, there is theoretically no limit to how high its share price can rise over time. Shares of semiconductor stock Nvidia Corp. (NVDA) are up 6,230% in the past decade, meaning investors have multiplied their initial investment by more than 63 times in that stretch. However, a stock can’t go lower than zero, so downside on a long position is capped at a 100% loss. For short sellers, that dynamic is reversed. If a stock goes to zero, a short seller makes a 100% return. However, a short seller’s potential losses are theoretically unlimited. If a stock triples or quadruples in value, a short seller may generate losses of 200% or 300% the size of the original short position.
Con: Short Sellers Risk A Short Squeeze
Both long investors and short sellers always risk the market taking a turn against them, but short sellers are at risk of a unique and potentially devastating market phenomenon: a short squeeze. Because short sellers must first borrow shares of stock from their broker, the broker often has the power to call in the stock or even buy it back on the short seller’s behalf if losses on the position grow too large. When a large number of short sellers are forced out of their positions all at once, the collective buying can be like pouring gasoline on a fire, sending a stock price skyrocketing in the short-term and forcing even more short sellers out of their positions at prices that often result in large losses.
Con: Stock Loan Fees
Investors who buy stocks in cash accounts are typically not charged any fees or penalties and can wait for their long thesis to pay off free of charge for as long as it takes. Short sellers do not have that luxury. Brokers charge borrow fees on stocks that can eat into or completely negate returns on a short trade over time. Unfortunately, these fees can be extremely high for stocks with limited shares available to borrow, which are often the most popular stocks for short sellers to target. In addition to the stock loan fee, short sellers must also pay interest on the margin they use, and they are responsible for any dividend payments made by the borrowed stock.
Con: Short Selling Mistakes Compound
All traders and investors make mistakes, but short selling mistakes tend to get more painful over time compared to long investing mistakes. If a long investment drops in price, it becomes a smaller percentage of an overall portfolio over time. A losing short position is exactly the opposite. “Mistakes become more painful as they run against you, since a rising stock on the short side becomes a larger percentage of your portfolio,” Tilson says. As a result, traders may feel more pressure to make an emotional, irrational decision on a losing short trade than on a losing long trade.
Con: The Market’s Long-Term Trend Is The Enemy
Short sellers are inherently going against the stock market flow because the global economy expands over time and equity markets grow along with it. Since 1996, the S&P 500 has generated an average annual return of 6.8% after adjusting for inflation. Over the past 200 years, the S&P 500 would have averaged an inflation-adjusted annual gain of between 6.5% and 7%, according to McKinsey. There are certainly plenty of stocks that have been terrible performers throughout the decades and there have been plenty of short-term market sell-offs providing short sellers opportunities to profit. However, Tilson says the long-term stock market trend has always been higher and is always working against short sellers.
More from U.S. News
Artificial Intelligence Stocks: The 10 Best AI Companies
9 Best Cheap Stocks to Buy Under $5
7 Dividend Stocks to Buy and Hold Forever
Should You Consider Short Selling? 5 Pros, 5 Cons originally appeared on usnews.com
