With the recent resurgence of the meme-stock short-squeeze back to where it was in 2021, it makes me think of the investors on the other side. The investors against “the people". The shorts, those who are betting against the stock.
We glamorise short selling. The financial media love to sensationalise negative forecasts that feed our negativity bias. Hit pieces and bearish markets calls from prominent investors and dedicated short funds are always pushed to the front page because pessimism towards markets will always appear more intelligent and tempting than optimism. Short selling is appealing to many, but does it make for a sound approach to investing?
In my opinion, shorting stocks is usually a terrible idea for most investors, especially long-term. Hopefully by the end of this post you’ll understand where I’m coming from.
Short-Selling 101
First, let’s quickly clarify what short-selling is for those unfamiliar with the practice. Like most financial concepts, it seems intimidating until you peel back the jargon and the reality is less confusing. If you’re already well-versed with the practice then feel free to skip ahead.
Short selling is generally used when an investor is speculating that an asset will fall in price. How this is actually executed is more complicated than simply ‘going long’ (buying something with the expectation that the price will rise).
To make it possible, an investor has to borrow shares of a stock from another investor and sell them to someone else, in the hope of later buying them back at a lower price.
If the stock price falls, the investor can buy the shares back at this now-lower price, and return them to the lender, pocketing the difference and making a profit. If the stock price rises, the investor incurs a loss, as they must buy back the shares at a higher price.
It’s this borrowing mechanism that makes shorting so fundamentally risky, particularly when used for speculation — even for those who are well aware of the dangers.
Say you think a stock is overvalued, so you decide to short it. You therefore borrow the stock, and sell it to someone else. The stock price is currently $10 and the price subsequently falls to $0 over the coming months. You then can buy back the shares for nothing and pocket the $10.
You borrow 1 share of a stock from a broker.
You sell this borrowed share to someone else for $10.
You now have $10 in your account from selling the borrowed share.
The company then unexpectedly files for bankruptcy and the price drops to $0.
You get to buy the share back for nothing since the stock price has dropped to $0.
You return the share to the broker from whom you borrowed it.
You keep the entire $10 you initially received from selling the share.
In this best-case scenario, you effectively make $10, which is 100% of the initial sale proceeds. This is why the maximum upside to shorting a stock is 100%.
This same process works against you if your speculation goes wrong.
You borrow 1 share of a stock from a broker.
You sell this borrowed share to someone else for $10.
You now have $10 in your account from selling the borrowed share.
The stock performs really well and the price subsequently rises to $50.
To exit the position you then have to buy back the stock for $50.
You return the share to the broker from whom you borrowed it.
You subsequently have lost $40 even though you initially risked $10. In other words you took a -400% loss.
So in theory, the maximum you can make when shorting is 100%, the maximum you can lose is infinite. The risk/reward here is clearly very negatively skewed against the short-seller when you consider it like this. It simply works against you.
For long-term positions it only gets worse. The more time you hold the position, the more likely it is to drift from the initial price and the more this negative asymmetry works against you.
As the stock price falls, the rate of change in your profit slows down because you are approaching the maximum possible gain, which is capped. The speed of your gains decelerates as the stock price moves closer to zero.
Conversely, as the stock price increases, the change in your downside gets exponentially bigger. The speed of your losses accelerate as the stock price increases.
This in reality means that the position becomes a larger part of your portfolio, and a bigger and bigger problem the more it goes against you. Exactly the opposite of what you want.
Shorting creates negative asymmetry where we have very limited upside, and unlimited downside. When performed enough times, this asymmetry creates a ticking time bomb unless you are that rare disciplined individual who can cut their losses before things get out of hand.
Yes you may get lucky for a while and manage to make good returns by shorting, but run this approach enough times and you will almost certainly incur a huge loss that will wipe out your previous successes.
On the flip side, being long an asset has positive asymmetry where we have limited downside (you can only ever lose what you put in), and theoretically unlimited upside. Comparing the risk/reward between the two approaches shows just how advantageous being long an asset is versus being short an asset over time.
We also haven’t talked about other trade-offs involved with shorting such as opening yourself to potential margin calls, having negative carry (where you have to pay to borrow the stock and forfeit any dividends). There is also the now very real potential of being short-squeezed, which can create truly disastrous results for short sellers.
This should be enough evidence for anyone considering shorting to avoid it. You will not be a hero, you are not as skilled as Jim Chanos or Michael Burry, and you will probably lose more than you put in.
Unless you know exactly what you are doing, understand how to properly manage risk, and have done the necessary work on understanding the assets you are shorting, you will eventually take a huge loss. Even when you do understand all of the above, this doesn’t stop those that do this for a living from blowing up their funds every so often.
Take Gabe Plotkin of Melvin Capital as an example. He had a fairly small portion of Melvin Capital’s portfolio betting against GameStop for years with the short position up around 30% in 2020 (hard data on how many shares they owned is not publicly available).
Fast forward to February 2021 after the GameStop short-squeeze and this initially small position ended up leaving the overall fund down -50% in a matter of months! This kind of implosion is usually unrecoverable in the hedge fund world and unsurprisingly led to Melvin Capital eventually shuttering its business in 2022.
Their maximum upside was a single-digit percent bump to their overall portfolio. Instead they ended up losing half of their entire capital. A once top-performing fund blown up by one mediocre position that was not properly managed.
While this is an outlier example, it clearly goes to show that speculative shorting creates inherent fragility. It can often devolve into ‘picking up pennies in front of a steam-roller’ as the famous saying goes.
Short funds can be a public good. Short selling incentivises investors to give market expectations a reality-check and has led to countless examples of fraud being unearthed over the years (e.g. Enron, Valeant Pharmaceuticals, Wirecard, Nikola). This helps to make markets more efficient, and punishes fraudulent or underperforming companies.
However, running this kind of strategy is extremely difficult, far more unforgiving than going long, and takes incredible discipline and resilience to stick with. Even if you have all these traits, you’ll likely still underperform a simple long-only approach.
I think this quote from legendary investor Stan Druckenmiller brilliantly summarises what we discussed above…
"One of the great hedge fund managers of all time, Bob Wilson, greatest short seller ever, said he made 90% of his money on the long side, the math just works against you.
If you're perfect on a short, you can double your money. But if you're wrong on a short, you can lose 10 times your money. If you're dead wrong on a long, you lose your money. But if you're right, you can make 10 times your money. It's a mathematical inverse of that with shorting. You don't have to be a rocket scientist.
I know, therefore, that if you have a bearish bias, you have to be very aware of it. You have to work around it."
The point Druckenmiller is making isn't to say that being bearish on an asset is stupid, it's that there's usually much better ways to position yourself and greatly improve your risk/reward than outright shorting something.
When does short-selling make sense?
So if outright speculative shorting is such a bad idea, why does anybody do it? Are there actually any benefits, and if you think an asset is going to drop in price, what should you do instead?
If you are bearish on an asset, it’s often better to simply just avoid any exposure and be long something more favourable. However, if you feel very strongly about your bearish outlook, it’s likely best to use ‘put options’ rather than shorting.
We’re not going to go into detail about put options here (and if you don’t know how they work you definitely shouldn’t be buying them), but in essence, they allow you to express bearishness towards an asset with a much more favourable risk/reward profile compared to shorting. Put options can be used either for speculation or for hedging.
Buying put options flips the risk/reward back in your favour, where your potential upside is theoretically very high, while your downside is capped. In other words, you can gain many multiples what you put in, and the maximum you can lose is your initial investment. This is much more comparable to the risk of taking a long position.
Though there are unique risks and considerations attached to using options, this approach works far better for longer term strategies or repeated attempts without the risk of blowing up or selling at inopportune moments.
Shorting can be useful as a part of a larger trading strategy. For example you can use it to execute a pairs trade (being long one position and short another) to create a ‘market-neutral’ position that benefits from changes in the two positions and dampens the effect of broader market trends. Pairs trades have the potential to make money regardless of how the overall market is moving. It’s worth pointing out that these trades can sometimes still end catastrophically. The same problems discussed earlier can arise but having a counter-opposite position that pairs with the short usually helps alleviate the damage; it rises as the short falls.
Both short-selling and put options can be used for hedging (protecting against an anticipated downside move in a position you already have exposure to). The idea is that the profit on the short or put option will offset the losses on the holding should that position fall in price.
While this is a legitimate use-case of short selling, put options are usually a better way to hedge positions. It’s also worth noting that employing hedging as a longer-term strategy is generally a net negative for most investors. It feels psychologically comforting to have some protection and this can make a strategy easier to stick with, but it comes at a cost and tends to drags on returns over time.
Shorting is arguably most useful for professionals and institutions. It can be used as a tool to provide liquidity for market makers. Large institutions can move prices in their favour by dumping borrowed shares onto the open market in high volumes in a bid to trigger stop losses and cause panic selling. There’s also the potential advantage of obscurity that comes with short-selling due to not needing to disclose short positions (whereas institutions must disclose any put options they own).
Both short-selling and put options have their place and can be useful. However, most of the uniquely beneficial use cases for shorting are esoteric applications that don’t concern retail investors. So if you are an experienced retail investor, and you want to express bearishness towards an asset, it’s probably best to use put options and to do so sparingly. For professionals, then there are times to short various things, but again, you should do so sparingly, and puts will still usually be the better alternative.
Bearishness will always be tempting.
I can definitely understand the allure of short-selling; it’s an interesting idiosyncrasy of our nature. Our bias for ‘loss aversion’ means we’re far more fearful of what we stand to lose should something go wrong, rather than what we could gain should things go well. We try to avoid pain and failure and we generally hate losing more than we enjoy winning (studies have shown that losses are twice as powerful as gains).
This loss aversion causes two things to happen in markets which don’t make a lot of rational sense when looking at them purely from a returns perspective.
People are motivated by what they stand to lose if they don’t act now. We irrationally want that thing more if we think it will soon become unavailable to us. This is part of the reason why markets generally get carried away more on mass euphoria than mass panic. Our bias for greed causes many more assets to be overtly overvalued than undervalued. This excessive, often downright delusional, optimism can continue for years until reality catches back up. The tendency towards dramatic overvaluation often lures people into thinking that shorting an asset is a smart idea, even when we know “markets can remain irrational longer than you can stay solvent”.
Loss aversion further contributes towards sub-optimal behaviour by pushing us towards wanting to feel safe and minimise risk. This causes us to seek downside protection and hedge our positions in an attempt to provide some psychological comfort, even though this approach has been shown to drag on returns over time.
Short-term shorting can work in rare instances, especially when both valuations and momentum are in your favour (excessively high valuations coupled with bearish momentum). But as discussed earlier, the risk/reward profile is always working hard against you and will likely cause problems unless you really pick your moments, which is incredibly hard to successfully pull off.
There are credible use cases for shorting, and bearish views can be extremely lucrative. However, it’s probably best for you and I to leave them alone.