Short-sellers have been bagging financial news headlines since the start of the year. Notably, the infamous GameStop short squeeze saga had investors looking into short selling and wondering if it’s the right stock trading strategy for them. 

Shorting, or short selling, is when an investor borrows an asset and immediately sells it. The goal is to wait for the anticipated decline in the asset’s price and buy it later at a lower value. Next, the investor returns it to the lender and pockets the difference. 

While short selling may be the perfect strategy for capitalising on falling stock prices and gaining lucrative returns, it comes with even more downside risk than buying shares the traditional way. Here’s why you should be more cautious before jumping on the short selling bandwagon. 

How does shorting stocks work? 

Before we get to the risks that short selling poses, let’s get a better understanding of how it works. The main purpose of short selling stocks is that the investor profits when the stock price falls in value. It means that you’re betting that the stock will see a decline in the immediate future. Generally, it’s the opposite of the normal process of buying and holding stocks, in which an investor buys a stock with the expectation that it will rise in price and it will be sold at a profit. 

Another main feature of short selling is that the seller is selling a stock that they do not own. This means they’re selling a stock before they purchase it. To do this, investors must borrow the stock that they’re selling from an investment broker. At that point, they can buy the stock for delivery, then close out the short position at a profit. 

You may be thinking, what happens if it doesn’t go according to plan and the stock price rises? In this scenario, a seller can choose to hold a short position until the stock does decline in price or they can cut their losses and close out the position. 

Should you sell short?

Short selling can be a great strategy when you’re certain that a stock will decrease in value. However, in addition to the previously mentioned risk of suffering a loss on a trade from a stock’s price increasing, there are additional risks that investors should keep in mind.

Potential for unlimited losses

The biggest downside risk when short selling is the potential for infinite loss. The upside of going long on an asset is that you know you can lose 100 per cent of your investment if the stock price falls to $0. While this loss is bad, at least your potential loss stops with your initial investment. On one hand, short sale losses are limitless. As an example, picture yourself buying a share of $50, then, its value increased by 600 per cent to $300. You will then buy back the shares, returning them to $300, and lose 600 per cent of your capital.

Be cautious when betting against a stock

No matter how dire a company’s prospects may be, there are several events that change its circumstances and consequently cause its stock to rally. Sometimes, no matter how much research you do or whatever expert opinion you received to lead you to short a stock, any number of events could trigger a share price surge.

Take for example what happened to GameStop. 

The shares of the American video game retailer were heavily shorted by hedge funds, with approximately 140 per cent of its public float being sold short. Early in 2021, users of Reddit’s WallStreetBets forum triggered a short squeeze in GameStop’s stock, causing it to surge to record-breaking levels to reach an unprecedented high of US$500 per share on 28 January 2021, almost 30 times the $17.25 valuation at the start of month. Losses on the short positions in the stock were estimated to billions of dollars. 

According to the New York Times, the viability of short selling as an investment strategy has also been called in question as a result of the GameStop short squeeze.

Additionally, you must remember that the stock market is volatile and speculative by nature. This means having a precise prediction of a stock’s movement is almost impossible. For instance, in the latest update in the GameStop saga, the company’s stock plummeted to a seven-week low after a disappointing earnings call. The decline follows a recent rally in the stock a week prior.

Meeting margin calls

Shorting is known as margin trading. This means that when short selling, you must open a margin account that enables you to borrow money from a brokerage firm using your investment as collateral. This will be used to cover a portion of your potential losses. You are required to maintain a certain equity percentage in your account. This amount varies, but if your account slips below the minimum, you will be subject to a margin call and you will be forced to put in more cash or liquidate your position. 

Time works against short-sellers

There is no time limit how long you can hold a short position on a certain stock. But it doesn’t mean you should. As mentioned, stocks are usually purchased using margin for at least part of the position, called margin loans. These come with interest charges, and you will have to keep paying them as long as you hold the stock. The interest charged can be viewed as a negative dividend and will be a regular reduction in your equity in the position. This means that the longer you hold on a stock and owe dividends, the lower your profits are going to be.   

Conclusion

Investing in stocks in the traditional way is risky enough. Short selling should be left to investors who have advanced knowledge and experience with stock trading and large portfolios that can easily shake off sudden and unexpected losses.

If you are a beginner investor, it’s also advised not to be easily swept up in by stock frenzies you see in the sharemarket. In his observation of the GameStop saga, Nigel Green, the chief executive and founder of deVere Group, warned to be wary of stock market fads. He warned that by being unaware of the high level of risk involved in these social media-led activist investment campaigns, people are playing a potentially very costly game.

“Extreme caution should be exercised before joining stock frenzies of this nature. The valuations can be expected to be wild – in both directions – and there’s a legitimate risk that novice investors could face a financial hit,” Mr Green advised.