Shorting a Stock: The Risks You Need to Know

While shorting is a part of any healthy market, that doesn't mean it's the best move for you.

Motley Fool Staff
Motley Fool Staff
Aug 15, 2018 at 9:26AM

If you think a stock is a little too expensive, it could seem like a smart idea to bet against it with a short position. However, the risk of unlimited losses can be quite scary, especially from a long-term point of view.

In this segment from Industry Focus: Financials, host Shannon Jones and contributor Matthew Frankel discuss the risks of shorting.

A full transcript follows the video.

This video was recorded on Aug. 13, 2018.

Shannon Jones: Matt, newly minted CFP, tell us all about the basics of shorting just to set the groundwork.

Matt Frankel: The short way I can explain short selling is, basically, you're borrowing shares of a stock from somebody else and selling them. You're selling stock that you don't own. Your hope is that the price of the stock will go down so that you can buy them back and give those shares back to whoever you borrowed from at a cheaper price than you sold it for, profiting from the difference. For example, say I wanted to short Apple. Apple is at its record high right now, I think it's gone too high, I could ask my broker to borrow 100 shares of Apple, sell it on the open market. Then, if I'm correct and Apple comes down a little bit, I can buy it back at that new lower price, give my broker back the 100 shares, and I get to profit from the difference.

The problem with that is, it creates unlimited risk of loss. To give you a quick example, I was looking at something I wrote on a blog a long, long time ago. Back in 2007, I thought Amazon was an expensive stock. It was trading at $39 a share. If I had initiated a short position in that for, say, 100 shares, that means I'm borrowing almost $4,000 worth of stock. If I had held on to that short position until today, I would be very wrong. Amazon trades for over $1,900 a share as I'm speaking. I would be sitting on a loss of about $187,000, on a roughly $4,000 short position. That's an extreme example, and I probably would have gotten out of the position as soon as it started really going in the opposite direction.

But that's just one example of how it can lead to an unlimited amount of loss if you're not careful. The listener who wrote in is definitely correct. It's a risky strategy in that respect. If you're buying the stock, the most you can lose is your investment if the stock goes to zero. But if you're shorting, there's no limit to how high a stock can go, so it makes your risk of loss infinite.

Jones: That's really the scary part, when it comes to shorting. Because of that infinite risk that's involved, there's really no ceiling on how high a stock could rise if you happen to be a short seller. The other key thing is, your thesis could actually be pretty spot-on, but you have to remember that the markets are irrational more often than not. Let's say you're shorting a stock where you believe the company is behind some sort of accounting fraud. The market may not recognize that. As such, the stock price continues to rise. And even though you may be 100% right at the end of the day at whatever point that comes, that could mean that your losses could be greater than 100%. It's this relative lack of control that keeps me from shorting stocks.

That's not to say that, A, it doesn't have a rightful place in the market. For any healthy capital market situation, you want to have people who are shorting stocks, particularly when you see valuations get exorbitantly high. With that being said, have to balance that with, it's not necessarily that short sellers are shorting stocks, or publishing short-selling reports, out of the kindness of their hearts. They're trying to make money. With that, there could also be some behind the scenes manipulation. You have to keep that in mind when you're hearing about some of these short-selling reports that come out.

But overall, shorting is a healthy part of any market that helps uncover things that the market itself may not have absorbed yet. Really good to see short sellers out there. But, for most long-term investors, just as you mentioned, Matt, the risk is so infinitely high, it's a much safer bet for most investors to stay away.

Frankel: Yeah. Like you said, short-selling definitely adds to the efficiency of the market by allowing people to bet in both directions. It helps control bubbles if an asset gets too highly priced. Short sellers can come in and keep that in check. And, it provides investors with a hedging mechanism. If I own a portfolio of ten stocks and it's gone through the roof, I could short an ETF, like we're about to talk about, to try to mitigate my risk.

If done correctly, it could be a healthy investment strategy. But you really need to be careful. You need to have a clearly defined exit strategy if you initiate a short position. In my Amazon example, if you don't have an exit strategy, it could have gone on forever and ever. It's really important to have a plan going into a shorting position. Like you said, generally, long-term investors are better off just buying stocks and holding them and not worrying about shorting.

Jones: Exactly. We certainly don't knock shorting as an important component of our markets. Even here at The Motley Fool, some of our services use shorting within their portfolios. It's certainly a tool that can be used, you just have to be very, very careful in how you do it.