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Shorting: Is the Risk Worth the Reward? (Insights from Market Gurus & the Pitfalls you Need to Avoid)

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What is Shorting?

Shorting refers to the practice of selling an asset (such as stocks or commodities) that the seller does not own with the expectation that its price will decline. The seller aims to buy back the asset at a lower price, making a profit from the price difference.

Is Shorting Worth it? Learn from Other’s Experience

“The whole purpose of education is to run mirrors into windows.” ~ Sydney J. Harris

Individuals who can look beyond their own beliefs, biases, and experiences and learn through others are bound speed up their learning curve rapidly. Throughout my investing career, I have always been a believer in doing my best to learn through other more successful and experienced investors rather than through trial and error. Why invent the wheel?

The hit movie “The Big Short” glamorized short-selling and influenced a generation of new investors. However, is short selling really worth it? Below are what two of the world’s most successful investors have to say about shorting:

“Frankly, I’m not sure I’ve ever made money, if I look back at the last 40 years. I’m afraid to look. I’ve never had a down year, but I’m not sure I’ve made money in shorts.“ ~ Stanley Druckenmiller

“It’s been my experience that it was a whole lot easier to make money on the long side.” ~ Warren Buffett

Below are five reasons investors should look to limit short-selling activity:

Stocks Trend Higher in the Long Term

Despite short-term fluctuations and the occasional bear market, historical data proves that the U.S. stock market is incredibly resilient in the long term and tends to trend higher. In investing, it is much easier and stress-free to trade in tandem with the underlying trend.

Zacks Investment Research
Image Source: Zacks Investment Research

The Math Works Against You

When you go long (buy) a stock, the downside is limited to 100% of the capital invested, and the potential gain is unlimited. Conversely, with shorting, there is technically unlimited risk.

The Risk of Ruin: Short Squeeze Risk

Legendary investors Bill Ackman and Carl Icahn famously squared off and took opposite sides of the Herbalife ((HLF - Free Report) ) trade nearly six years ago. Bill Ackman shorted the stock, believing that Herbalife was a pyramid scheme and the company was not fundamentally sound, while Icahn went long the stock knowing that he could “squeeze” Ackman out of his short position. While it remains to be seen whether HLF is technically a pyramid scheme, Ackman was correct about the company’s poor fundamental picture. However, Ackman lost hundreds of millions on the trade while Icahn profited handsomely.

Another classic example of how dangerous short squeezes are is the GameStop ((GME - Free Report) ) / Reddit phenomenon. An online message board of retail investors realized they could squeeze then-billionaire Gabe Plotkin and Melvin Capital out of their GME short position. Once again, the stock rocketed into the stratosphere, despite the fact that the fundamental picture was lackluster. Melvin Capital would later be forced to close its doors. If it can happen to Ackman and Melvin Capital, it can happen to you.

Zacks Investment Research
Image Source: Zacks Investment Research

Vicious Counter-Trend Rallies

Successfully timing the market and predicting price movements accurately is challenging regardless of what side of the market you are on. However, on the short side, it is much more difficult because of the vicious counter-trend rallies inherent in down-trending markets. Below is a three-year Nasdaq 100 ETF ((QQQ - Free Report) ) chart as an example:

Zacks Investment Research
Image Source: Zacks Investment Research

Potential Incurred Costs: Margin Calls & Dividend Payments

If the shorted asset’s price rises, the broker may issue a margin call, requiring the short seller to deposit additional funds to cover potential losses. Short sellers may be required to pay dividends to the entity from which they borrowed the asset, adding to the overall cost of the short position.

Bottom Line

On shorter time frames, markets fluctuate, and there is a time to be short. However, investors should focus on long opportunities more often than not as risks are much lower and the risk-to-reward is much more favorable, all else equal. In other words, never pick up pennies in front of a steamroller.

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