The Perils of Short Selling a Stock

Published March 20, 2017
Fool.com

Some stare atSnap's(NYSE: SNAP)valuation and wonder if shorting the company now might be a good idea.

In this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and Jason Moser dip into the mailbag to answer a listener's question: Why is shorting a stock so much more dangerous than going long on a company?

Listen in to find out how shorting works, why it is a much riskier and more complicated bet than simply buying shares in a company, and more.

A full transcript follows the video.

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This podcast was recorded on March 10, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 10, and we're talking tech and the perils of shorting a stock. I'm your host, Dylan Lewis, and I'm joined in the studio by Motley Fool Premium analyst, Jason Moser. Jason, how's it going?

Jason Moser: Hello, sir. All right, how are you?

Lewis: Working on getting over a cold.

Moser: You and me both.

Lewis: Yeah. We're going to try to make it through this episode without hacking. I picked the perfect person to be on.

Moser: We're going to have to. This is going to take double effort here.

Lewis: You have a little mug of tea.

Moser: I do. I figure this helps. I thought it would be coffee, but I think coffee actually dehydrates you a little bit, oddly enough. It's mostly water, but apparently it's not good for you.

Lewis: Yeah, tea is a much better option.

Moser: Yeah, that's what I'm understanding, and so far it's working, so let's hope it lasts.

Lewis: So, listeners, please excuse any huge coughing fits. I have a 32-ounce bottle of water next to me as we do this show. We're going to try to make it through, though. But after our episode last week, Snap and the morning after, we talked about the market reaction to Snap's IPO. We got an email from one of our listeners, this guy Chris, and he asked, "Dylan said that the risks from shorting could be catastrophic. How and why can shorting have more potential for catastrophic loss than buying into a company?" We wound up getting a similar-ish question on The Motley Fool podcasts Facebook group, which is awesome, if anyone isn't a part of that, check it out. We bounce ideas back and forth; it's a great place to connect with the cast and other Fools that are interested in the podcast. Just a plug.

Moser: Make fun of people on the podcast. Bill Barker is a subject of joking there.

Lewis: Yeah, he gets jabbed two decent amount. But, someone in that group also raised something similar with the idea of potentially shorting Snap. I love it when people drop these kinds of questions, because it gives us a great lens into what people are thinking about the market, and what they want addressed on the show. So, I figured that we would tackle this topic, talk a little bit broadly about shorting. We've talked Snap to death at this point, I think we've done two out of the last four Tech episodes about it. So we'll try to keep it away from Snap and mostly just about the mechanics of shorting, and the pitfalls that people need to be aware of. But, I think, before we get too much into the downside, we should walk through some of the mechanics of shorting itself, and what you're really doing when you're shorting a stock.

Moser: Yeah. Shorting a stock, first and foremost, is basically placing a bet on its demise. You're betting against it. Normally, what we do so much of here is recommend that people buy stocks, and we think those are going to be good investments for the long haul, they will appreciate in value. When you short a stock, you're basically betting that stock is going to fall or depreciate in value. There could be any number of reasons you short, but ultimately, you're basically borrowing a stock from your broker, selling it to someone else at a given price, and then at some point, you're going to need to buy it back and return it to the broker. So, if you short a stock, then ideally, you want to see the price go down after you short it, so you would be able to buy it back at a lower price. You get to pocket the difference.

I think the biggest problem I have with shorting, and to the question that the listener was asking, is, if you think about it: When you buy shares of a company, when you invest on the long side, the very worst case scenario is you lose all of your money. So if you invest $1,000 in company XYZ and company XYZ goes bankrupt, you might lose your $1,000. And that sucks, no one wants to do that. But that's the downside. It's quantifiable. The thing with shorting the stock is, you can lose a lot more than 100% of your money. You short a stock XYZ at $100 a share and then XYZ takes off and six months later it's $500 a share, well, you're stuck, you've lost a lot more than 100% of your money. I think that's probably the scariest part, to me, about shorting. There's far more downside than if you were just going to buy shares of a company and hold on to them as a long investor, like we do.

Lewis: Yeah, I think the best way to think about it is, you take the upside-downside of going long and flip it. That's basically what you're looking at. As a super basic example here -- and a lot of what we're going to be talking about on this show is basic shorting, not working with any options in addition to a short position, just to keep things simple. But, say you borrow one share at $10, you're selling it immediately. $10 gets deposited into your margin account. Then you have one of two scenarios playing out. Say shares are at $7 a week later, at which point you would probably buy a share and then return it to your brokerage, pocket the $3, maybe minus any fees or anything like that. Scenario B, shares are at $13 a week later, in which case you'll probably get a call from your brokerage saying, "We need you to put more money into this margin account to cover the losses, because right now you can't do that with only the $10 that is currently in your account."

Moser: Yeah, and that's a good point. A lot of this stuff is out of your control at some point, maybe. When you're borrowing those shares to then sell them off to someone else, you can't just do that for as long as you want to do it. There are a lot of other factors at play that could dictate what you have to do at some point in the future. Whereas you could buy shares of Amazon (NASDAQ: AMZN) tomorrow and hang on to them for the next 20 years if you want, and nobody can take it away from you unless it's taken private or acquired by someone else, and, obviously, that's not likely to happen. But with shorting, it seems like you don't have the same freedom there.

Lewis: I think one of the other dangers that we see with shorting is this idea of getting a margin call, and being in this position where you've already made that initial bet, and then you're going to have to decide whether or not you want to keep going at it and keep banking on that short position and that thesis against that company, or if you ultimately want to buy shares at the market price, which is above your position, and just eat the losses.

In that second example, if you decide not to put more money in your margin account, basically, you'd wind up buying shares back at the market price, which would be $13, and you would close out the position and eat the $3. Of course, you could put more money in your margin account, and shares could go up to $15 or $20, and then you're back in the same predicament. So, you could wind up in this incremental [situation]. Keep digging in the hole, and it keeps getting darker and darker, and dirt keeps going up on the ground, but you can't see the sun.

Moser: Yeah, it's funny, shorting, to me, is one of those situations where -- and I don't do it, I'll be very clear, to me it's not worth it -- but you could be totally right in theory. If you come up with a thesis as to why to short a stock -- "This company's cash flow is not as good as they report," or maybe you think management is crooked, or whatever you think it is -- you could actually be totally right, but there's that saying: The market can remain irrational far longer than you can remain solvent.

Lewis: Which is a big concern.

Moser: Yeah. At the end of the day, the market is going to have the say-so in this. To me, shorting a stock, you could be totally right and still totally lose, and there's nothing you can do about it.

Lewis: And to that point, in a lot of situations you're basically paying to watch your thesis play out, because very often, there's a stock loan fee associated with shorting. So, unlike when you're long and you buy shares, and you probably pay a commission to buy your shares, that's it. You hold them, you hold them for as long as you want, and you can watch the stock go up and down and just enjoy the entertainment there, in addition to seeing what goes on with your portfolio. But as you hold or maintain a short position longer, it's going to cost you more money in fees.

Moser: Yeah, you're paying for it.

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.

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.

Lewis: That does it for the stuff I wanted to hit with shorting stocks. Anything you want to hit, Jason?

Moser: I think it's one thing to read the headlines, especially with these big IPOs that come out, and that's always going to be the bull versus bear pull out of there. I think Snap is the easiest example, but Twitter, certainly. Facebook is another one. Amazon is a great example of a business where you've had so many people who have thought for so long, "This just doesn't make any sense, the stock is way too overvalued, they don't earn any money," and it's all because Jeff Bezos reinvests that money into the business. Again, a good example of where you could have gone short on Amazon, and it would have made sense to the extent that the business isn't producing any real earnings. But when you dig deeper, and you understand why it's not producing earnings and what it's doing and the competitive position of the business, and the opportunity, then you recognize why the market is assigning such a hefty valuation -- because really they see that Amazon is looking so far forward with this big opportunity in e-commerce. So, I feel for anybody who was shorting Amazon from that perspective. And I think tech in particular, it's very difficult to go in there and make those kinds of calls. I'm not saying don't short, but certainly, make sure you understand everything involved with it before you do it, because I have heard from one or two investors who have come out on the bad end of that, and it's just really sad to hear.

Lewis: Yeah. You don't want to dig yourself a hole that you're going to have trouble getting out of. We talked about things, like I said, in a basic overview type format here. There's a lot more nuance to it. I think at some point down the road, we'll probably do something that talks about bearish bets with options, because there's clearly listener appetite for that. So, listeners, you can be looking out for that and expecting it to be an episode at some point soon. I realize this is kind of a quicker episode, but we are teeing up for our South by Southwest trip, so we were a little bit busy this week.

Moser: Nice. You say "we," it's you, not me. I'm going to be sitting here while you guys are out there in Texas. Listening to music, eating barbecue, probably drinking a cold beer or two.

Lewis: Yeah. I guess we're also going to go to some sessions, though. You guys are going to be getting some not-so-great weather here.

Moser: I understand. Thanks a lot, I appreciate it.

Lewis: [laughs] That's all to plug some of The Fool team being in Austin for South by Southwest. We're also going to do a listener-and-member meet up while we're there.

Moser: That'll be awesome. It seems like a great response every year, when you all head out there.

Lewis: I think last year, we were at Guero's Taco Bar; that's what we're doing again in Austin. If you want information on what's going to be going on, just shoot us an email at industryfocus@fool.com. We'll get you the info if you're going to be in the Austin area. Last year, we had maybe two dozen folks hanging out with the analysts.

Moser: Dozens of listeners! [laughs]

Lewis: Dozens of listeners! I think everyone that listened to the show came! Which is amazing. But, yeah, feel free to reach out on that email, and we'll make sure you have all the info. Obviously, next week, with most of the tech-following people and the Market Foolery host, Chris Hill, being there, we are going to be super South by Southwest heavy with our content. All of next week for Industry Focus is going to be South by Southwest-related. It's either going to be me or Simon Erickson calling in boots on the ground.

Moser: Sounds like fun.

Lewis: It should be good. Anything else before I let you go, Jason?

Moser: Safe travels, my man! We'll see you when you get back.

Lewis: All right. Enjoy the cold weather!

Moser: Well, thanks!

Lewis: [laughs] Listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program might own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Jason Moser, I'm Dylan Lewis, thanks for listening and Fool on!

Dylan Lewis owns shares of Facebook. Jason Moser owns shares of Twitter. The Motley Fool owns shares of and recommends Amazon, Facebook, and Twitter. The Motley Fool has a disclosure policy.