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Pros And Cons Of Short Selling – Why Is It Difficult? – [Short Squeeze] – Disadvantages Of Short Sellers

Short selling often makes headlines because of so-called short squeeze or when the media is full of predictions about a market top. Stocks are at an all-time high in terms of valuation, commodities have been on a roll, and interest rates are low (and can only go up?). Unfortunately, profiting from a bubble that bursts are insanely difficult.

Short selling is difficult because you are betting against the upwards bias, at least in the stock market. Even worse, you need to pay interest for the privilege of selling short. Additionally, all markets tend to drop fast when they do fall, while most markets rise slowly and gradually. Short selling is much more about market timing compared to when you go long. Short selling is an art that very few masters and mostly involves luck and randomness.

We start the article by explaining exactly what short selling is:

What is short selling?

We divide this section into two: one for short selling stocks and one for selling short derivatives:

How to sell short stocks

If you own shares in a company, you obviously own a piece of the company alongside the other shareholders. If you decide to not be an owner anymore, you sell your stock. We assume everyone understands this concept.

But if you sell short a stock, you are actually selling something you don’t own. It sounds both counterintuitive and illegal, but we can assure you it’s both logical and certainly very legal (if done according to the books).

You sell short stocks by borrowing stocks from your broker (which borrows from other customers who have accepted to lend out their shares for short-sellers). Those who lend out their shares get a fee for doing so, normally interest, which they normally split with the broker.

Here’s how it works:

Investor A owns 250 shares of Apple. He would like to add some “income” by lending out his shares to traders or investors who are bearish.

Investor B is bearish on Apple, believing it’s overvalued and believes he can profit from a future decline in Apple’s share price. Thus, he wants to sell Apple short: sell today and buy back at a lower price later.

Investor B checks with his broker’s stock inventory to see if he can borrow shares to sell short. He finds out that the short inventory is 1 000 000 shares at 5% annual interest. The shares available for short selling are “pooled” by all customers who have agreed to lend out shares. Short-sellers can easily check the availability and costs before they short.

Investor B borrows 500 shares from his broker (which the broker has borrowed from investor A) and sells them in the market for 230 dollars per share. He is now short. At a later time, he would need to buy back the shares and give them back to the broker (and the broker to Investor A).

Some months later the share price drops to 200 and investor B wants to take profits, and thus buys back the shares in the market. The profits are 230 minus 200 multiplied by 500 which equals 15 000. If the price had risen to 500, Investor B would have suffered a pretty big loss of 135 000.

While being short Apple, Investor B has paid 5% annually for borrowing the shares. Who gets this interest? It depends on the agreement with the broker, but normally the broker rakes in the most, and a smaller part goes to Investor A who agreed to lend his shares.

If Apple paid a dividend while Investor B was short, Investor B is required to give it to Investor A who is the formal owner of the shares.

Naked short selling

To avoid selling something you don’t own (naked short selling), your broker makes it impossible to sell something you don’t own or have borrowed. Naked short selling involves artificially increasing the float and is, of course, strictly illegal.

Sell short futures contracts and other derivatives

Derivatives are slightly different than stocks:

If you want to sell short derivatives, you simply sell them – even if you have not borrowed any contracts. Derivatives are a zero-sum game. For every contract, someone is long and short. If you buy an S&P 500 futures contract, someone else must issue that contract. If you gain, the counterparty loses.

Selling short means unlimited risk

A stock can only fall 100%, but it can, theoretically, rise unlimited. Gamestop was trading at five dollars in August 2020, but in February 2021 it was trading above 300 dollars. If you were short all the time, you would have been taken to the cleaners! (Most likely your broker would have forced a margin call before that.) That’s a 6 000% loss, while the potential gain was 100%, and the latter is pretty unlikely. The risk-reward is poor! Short sellers are very liable to tail risk:

What is a short squeeze?

I signed my first client and proceeded to short my first stock. It almost proved to be my last. Over the next few weeks, I watched the stock trade up to 20, then 30, then 40, finally breaking through 50…..But when the stock climbed past 50, I started to cover, unable to stand the pain. It was too late, however, a major bear squeeze was on. I covered the last of my position between 90 and 95. I lost the entire initial $25 000 stake plus $50 000 more…..A month after we closed out our position, RH Doe declared bankruptcy. One day, shortly after the Hoe debacle, I was moping along Broadway when I ran into Wilton (“Wink”) Jaffee, and old Wall Street hand and a veteran of many campaigns. As we talked, I blurted out something about “The biggest boom and bust cycle I’ve ever seen in a stock was in Hoe”. Wink replied with a chuckle, “Oh yeah, we had some fun squeezing the shorts on that one. Really took some of those midwestern hayseeds to the cleaners.”

Victor Niederhoffer, The Education of A Speculator, page 267-268.

The main problem is, as you surely understand by now, that the risk/reward is not optimal when selling short. A short squeeze, just like what happened in Gamestop and in the example of Niederhoffer above, makes you liable to unlimited risk.

When short sellers need to cover their position, they add fuel to the fire because they need to buy back shares and return them to the broker (short squeeze)  Short sellers normally deposit collateral with their brokers and are often forced to cover their position or add more collateral/margin if the position goes against them.

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Also, short-sellers normally give up at the same time. It’s a vicious cycle. If the outstanding shares sold short are high relative to the float, even more shares are buying the limited offer of shares. A fund that is short 100 000 shares in a stock that has 50 000 shares in daily turnover, would take more than two days to buy them all back. The exit door is small.

The market is like a large movie theater with a small door.

Nassim Nicholas Taleb

Short-sellers face another risk: your shares could be called-in by the broker. This happens when customers of the broker start selling shares and thus the inventory gets depleted.

Short squeezes are rare, but many get the impression they happen frequently because when they do happen they get a lot of media coverage. We have tried to develop a short squeeze trading strategy, but the fact is that a high short interest ratio is an indication of future poor performance.

Alternatives to selling short

Because of the unlimited risk when selling short, we recommend another option that has limited risk:

You can buy a put option. When you are long a put option, you can only lose what you paid.

A put option offers you the right to sell a stock at a predetermined price (but it’s not an obligation). You need to pay a premium to the issuer (remember, the derivatives market is a zero-sum game) for the rights for this insurance. The option premium is dependent on many factors, the most important being the price of the underlying asset, the volatility, and the time until expiration. Even though it’s a long position, you benefit if the price of the underlying asset drops.  

The main advantage is obvious: you can only lose the premium you have paid. For example, if you paid two dollars per option contract, which equals 2 000 USD for 1 000 shares, your max loss is 2 000 USD. Compare this to being short Gamestop and face forced liquidation or margin calls!

If the strike price of the put option is 100 and the price of the underlying stock is at 80 at the expiration date, you exercise the option (of course) and sell it for 100.

Pros and cons of selling short

Let’s look at the pros and cons of short selling. Despite its difficulties, there are tremendous benefits of having short trading strategies in your portfolio.

Short trading strategies don’t need to be particularly good on their own because they normally add diversification and risk mitigation. Let’s look at some of the pros of short selling:

Selling short offers diversification

Someone who has proved himself as a successful short seller will find himself in great demand among institutions. The reason is simple: diversification.

Adding a fund/asset that goes the opposite way in bear markets adds huge benefits to a long portfolio by smoothing returns and increasing the “efficient frontier”. A pension fund might allocate 3% to a short-only fund with the aim of reducing losses when the markets fall. Please read the article correlation in trading and Mark Spitznagels’s Safe Haven Investing to better understand the importance of this concept.

Selling short offers reduced volatility

Because of diversification a portfolio most likely reduces volatility and even increases the annual return (CAGR). Read here to understand why arithmetic and geometrical returns differ in trading and investing.

Selling short hedges your portfolio

Perhaps needless to say, but being short offsets losses in long positions. In a bear market, you reduce losses.

However, keep this in mind when you are dealing with a short trading strategy:

Selling short is betting against the upward drift

The stock market has over the last 120 years an annual return of close to 10%, according to Dimson, Marsh, and Staunton in the Triumph of the Optimists.

When you are short, you are betting against the upward bias. You are betting against innovation, inflation, corporate profits, and perhaps even multiple expansion. Add to this borrowing costs and fees and you understand the odds are stacked against you.

Or is it?

Hendrick Bessembinder published a study a few years back that revealed just a few stocks contributed to the long-term tailwind in stocks. This is further “proven” by the fact that most retail investors perform poorly and lag the indexes a lot.

Selling short has limited upside and unlimited downside

A stock can rise unlimited, but can only fall to 0.

Selling short is hard because stocks and markets fall hard and fast

A bear market happens fast and doesn’t last long. The stock market discounts a bleak future rapidly, while a bull market rises slowly and over time. In our previous article about the 200-day moving average, we calculated that the S&P 500 has spent 70 percent of the time above the 200-day average since 1960 and 85% of the time since 2010.

Here is a personal anecdote: when we were day trading in 2008, our best year, the market was down 55% at the most. Still, we made 2x the amount on the long side compared to the short side.

Why is that?

It’s because of the velocity of bull and bear markets. Bear markets are very explosive.

Let’s look at some data in the S&P 500 from May 2008 until the bottom in early March 2009, when the index lost 50% of its value:

  • 99 days were up and 104 days were down.
  • The average up day was 1.79%. The average down day was minus 2.32%.
  • It was 51 days with a rise >1%, 30 days with a rise >2%, 76 days with losses >1%, and 45 days with losses >2%.

As you can see, there were plenty of great long days even though the market fell a lot. This makes short selling difficult! Volatility explodes during bear markets.

Below is the graph showing a 25 day moving average of the absolute values in the daily changes from close to close:

Pros and cons of short selling

Selling short requires volatility to make money

When the S&P 500 is above the 200-day moving average, the daily volatility is 1.05%. When the index is below the average, the volatility increases to 2.1%.

Clearly, the price action is completely different depending on the price being above or below the long-term moving average.

Selling short involves opportunity costs

Time spent chasing tops in the market might be much better spent in developing low-hanging fruit from the long side. Opportunity costs are about allocating money and time. Why go for the third-best option if you can add to the best option?

Short selling is betting against the casino

Casinos make money because they use the law of large numbers. They make a small profit on each roll of the dice or wheel. Because so many go to the casino to play, they are practically certain to make money in the long run.

If you are shorting stocks or are a permabear you are betting against the casino. Selling short involves a great deal of luck and timing. Some investors got famous for predicting the crash in 2008, but hindsight is everything. Every day there are people predicting crashes, and some will eventually be right.

We have been trading for 20 years, and we long time ago concluded that it’s extremely difficult to find a consistent short-selling strategy that works – in any market. Profits are mainly due to chance and luck. Additionally, short selling only works a small percentage of the time. Don’t believe you are a genius if you accidentally manage to call a top.

The best way to make money in the markets is by finding strategies with low volatility (high profit factor and Sharpe Ratio). If you manage to find a portfolio of uncorrelated strategies, the holy grail of trading, you can perhaps add a little leverage to your trading. Chasing short opportunities and timing tops leaves you prone to left tail events and costly mistakes.

Short selling trading strategies

Despite all the negativity in this article, it’s still possible to find profitable short strategies, but they are rare.

Short strategies are best in bear markets – simply because volatility picks up a lot. Short strategies require volatility to work.

Below we have an equity chart for the S&P 500 that only takes trades when the close yesterday was below its 200-day average (plus two additional variables):

short squeeze

The chart above contains the sum of both long and short trades and has the following data:

short squeeze

The three variables are the same for both long and short, except they are opposite. Perhaps even better, 45% of the trades enter and exit on the same day.

The CAGR is 5.6% while being invested only 4.6% of the time. We think these are pretty impressive numbers!

The Trading Edge will be published as a monthly edge at a later time:

(We have also developed some very profitable short strategies in XLP – consumer staples and they too will come as monthly Trading Edges.)

Conclusion – why short selling is difficult

Selling short is difficult because of the upward bias in most markets, and markets tend to drop much faster than the rise. Even worse, you have to pay interest and fees for being short. And not to forget the inevitable short squeezes that happen from time to time.

Selling short leaves you vulnerable to left tail events and tail risk. The risk is unlimited.

Selling short often means windfall profits but it’s a tough game to win. Don’t chase tops in the market!

We have a general rule: when you short a stock, keep saying to yourself that short-selling is difficult.

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