More Reasons To Be Wary Of Shorting Stocks

Shorting a stock is a complicated way for investors to play out their bear thesis, but it's also incredibly dangerous financially and its risks are generally much greater than any potential gains it might garner.

In this clip from Industry Focus: Tech, host Dylan Lewis is joined by Motley Fool superstar Jason Moser to explain a few of the more technical reasons that shorting a stock is unlikely to be worth an investor's time, whether they're justified in their bear case or not.

A full transcript follows the video.

This podcast was recorded on March 10, 2017.

Dylan Lewis: So, beyond to the margin calls, there's going to be other things coming in there and eating into what your potential returns might be.

Jason Moser: Yeah. And I mean, I like the fact that you can short stocks. I think it's a good thing for the market, and it's good for the liquidity side of things, and there's plenty of big finance out there that wants to short big lots of shares of stocks. Whatever, that's all fine. I don't have a problem with it. I just think for individual retail investors like us, it's one thing to make a bear call on a stock, it's another one entirely to sit there and make a bear call and decide to short it. I think, for me, I have more entertainment in making the bear call and following it. The reward is just not there for me in shorting. I'm just not feeling it.

Lewis: And in a basic short, your returns are more or less limited to 100%. Whereas if you go long something, you can have a multi-bagger, and you're going to be doing 1,500% in returns or something like that, if you hold something over a 10-year period and it's a really explosive growth stock. So, for the asymmetrical risk you take on, the upside isn't really all that fantastic.

Moser: No. And you mentioned options. There are ways you could short a stock via options if you just wanted to buy a put or something like that. However, if you want to utilize an options strategy to do it, that would at least cap your downside. But, again, you're getting into options, which is a far more esoteric way of investing. Some people just don't prefer to do it. It requires a bit more attention and time.

Lewis: That will be a follow-on episode to this, I think.

Moser: Make sure to bring Jeff Fischer for that one.

Lewis: Sure, I'll be talking with Jeff Fischer or JP Bennett, I think, for that one. A couple other things I think are worth keeping in mind here when you're talking about shorting a stock, maybe reasons against it, you are super-subjected to really big downside when it comes to earnings surprises or M&A activity, or anything that's black swan-y, like, say, Brexit or the U.S. election results. It looked like Brexit and the U.S. election were going to have huge impact downward with the market. And what did we see a couple weeks later? Right back up. And long term, we've seen nice capital appreciation in the equity market.

Moser: Sure, absolutely.

Lewis: So, maybe a company blows earnings out of the water, and even though long term, you might be right, like you were talking about, the immediate market reaction is going to be positive, and you're going to have to deal with it with margin calls and things.

Moser: Yeah. I think shorting is certainly more of a short-term style investment vehicle. You're focusing, I think, on a much shorter timeline than we like to focus here as business-style investors.

Lewis: Yeah, absolutely. A couple other things to keep in mind: You're generally betting against the motion of the market. You think about what's going on on a multi-year basis. The market, the S&P 500, at least, tends to climb. I don't see that changing on a multi-year basis. So, yes, while we're looking at shorter horizons, when you're talking about short selling, it's tough when you're going against the momentum of everything, against the grain of everything.

A couple other more nuanced elements of shorting: You are on the hook for dividends that are paid out while the shares are on loan, so you'll have to pay those along to the brokerage, not that you would necessarily be shorting a dividend-paying stock, because they tend to be a little bit more stable, but that is something to keep in mind. Additionally, if you are looking at an uncovered short -- so, when you don't have any options at play, you don't own any of the underlying shares in any way -- those are treated as short-term capital gains, which is something to keep in mind.

Moser: Yes. When you have a tax bill you have to deal with in any which way, you always need to keep that in mind.