Institutional Investors

The Balance: Short Selling Stocks – Not For The Faint Hearted

Here’s another article that I edited at The Balance: Short Selling Stocks- Not for the Faint Hearted.  The original author started out conservative on the topic, and I took it up another notch.

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Q2 hedge fund letters, conference, scoops etc

Short Selling Stocks

mohamed_hassan / Pixabay

For this article, I:

  • added the information about changes to the uptick rule (which did not reflect anything post-2006),
  • corrected a small math error,
  • made the example more realistic as to how margin works in this situation,
  • added almost all of the section on risks
  • totally rewrote the section on picking shorts (if you dare to do it), and,
  • added the famous comment by Daniel Drew.

I have shorted stock in my life at the hedge fund I worked at, hedging in arbitrage situations, and very rarely to speculate.  Shorting is a form of speculation shorts don’t create economic value.  They do us a service by pruning places that pretend to have value and don’t really have it.

In general, I don’t recommend shorting unless you have a fundamentally strong insight about a company that is not generally shared.  That happens with me occasionally in insurance where I have spoken negatively about:

  • Penn Treaty
  • Tower Group
  • The various companies of the Karfunkels
  • The mortgage and financial guaranty insurers
  • Oh, and the GSEs… though they weren’t regulated as insurers… not that it would have mattered.

But I rarely get those insights, and I hate to short, because timing is crucial, and the upside is capped, where the downside is theoretically unlimited.  It is really a hard area to get right.

Last note, I didn’t say it in the article, and I haven’t said it in a while, remember that being short is not the opposite of being long — it is the opposite of being leveraged long.  If you just hold stocks, bonds, and cash, no one can ever force you out of your trade.  The moment you borrow money to buy assets, or sell short, under bad conditions the margin desk can force you to liquidate positions — and it could be at the worst possible moment.  Virtually every market bottom and top has some level of forced liquidations going on of investors that took on too much risk.

So be careful, and in general don’t short stock.  If you want more here, also read The Zero Short.  Fun!

Article by David J. Merkel, CFA, FSA, - The Aleph Blog


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