Shorting stocks is hard: our series ends with this overview
Knowing about the more challenging aspects of the stock market helps a new investor reach a better level of understanding it. Although shorting stocks is hard, and not for beginners, all investors need a basic understanding and awareness of shorting.
For their benefit, and to best understand the market, novice investors should know the basics of short selling. That helps a novice understand the effect of shorting activity on the market. Knowing always makes an investor better, more comfortable, more confident and able to invest well.
In the White Top View blog posts, explanations are basic and introductory. We discuss advanced techniques such as shorting to make beginners aware of the market effects of such techniques.
Today’s post if the last part of the White Top View series, the Short Story on Short Selling, Part 12, Shorting stocks is hard.
Click the links at the bottom of the post to read any part of the series.
Shorting stocks is hard, demanding and taxing
Shorting stocks is hard because it takes knowledge, experience and the right psychology. The successful short seller has a favorable, strong and resilient psychological makeup.
Shorting is a very aggressive strategy. Not for casual play. To profit and offset all the risks and restrictions, successful short sellers must aggressively play their positions. This is the rough and tough end of the market. Shorting is not for everyone and most certainly not for beginners.
Finding good short targets takes knowledge and experience well beyond that of a beginner. Specific short target selection is also beyond the basics we discuss here. We will stay with some generalizations to give you the flavor, if not the specific techniques, of good short selling.
Selling short is not just the opposite of buying shares long. Selecting short targets requires much more than calculating basic stock valuations. Do not short a stock simply because it has gone up a lot.
That is as bad as someone making money from a rising stock but selling it because it has gone up a lot. Selling winners is the single biggest long investing mistake that I see. And I see it far too often.
Psychological demands of short selling
Superior performing short sellers are thick-skinned tough and willing to take on man, woman, child, market, company, industry, brokers, you and your mother-in-law!
Psychologically the world opposes the short seller. All are against these predators of the market. Even when the facts should favor the short, plenty of negative stories about them and their ill-founded, unreasonable, illogical and badly researched position will emerge.
Being short is incredibly mentally taxing. It demands much cerebral flexibility and strength. Psychologically shorting is only for people willing and able to stand alone, sometimes for a long time.
All the typical bellowing about short activity is a bit rich. Especially, considering that the only reason any of us are in or even interested in the market has only to do with making money! Going short is perfectly legitimate. Still shorting is psychologically very taxing.
Three best short characteristics
Stocks that rank among the greatest short sale candidates have one or more of the following characteristics:
Fraud is the very best news for a short. In other cases shorts can simply attack a company with bad management or poor financial controls. Even if correct about bad numbers, shorts are always challenged to get the timing right.
Obsolete Product or Service
Obsolescence can take forever! And that is often very much longer than you think could be possible. Once the market grasps the facts, playing an obsolescent product or service, makes a great short. Again getting the timing right remains a challenge.
Usually inferior management accompanies either or both accounting and obsolescence issues. At times, ineffective management misses good business situations or opportunities. When the short know this, they can undertake a campaign to convince more investors. Very nasty, expensive battles using many lawyers are a show! Frequently major shorts put together the better business idea, a new management team and try selling it to other shareholders.
Shorts need to constantly manage their position
There is no such thing as taking a passive short position. Playing short is a very hands on active strategy requiring active management.
Advanced topics like the techniques of effectively managing short positions are beyond any basic discussion of shorting.
Management can use an extensive toolbox to counter attack
Short sellers must expect a very aggressive counter attack orchestrated by management. Management deploys many weapons without hesitation. Included are:
Public and Private Lobbying
News Releases including fiction and fluff
Insulting the short seller, as well as calling out their reason and heritage (yes it can get that nasty)
Both using and defending against this extensive arsenal gets very complicated and certainly keeps the lawyers busy. To keep our discussion to a basic level requires that we mention these many weapons get used by a plethora of techniques.
Be aware of a dangerous short phenomenon
Shorts must cope with some financially dangerous phenomena.
1. Shrinkage: As a shorted stock falls, the short seller must press their position to maximise their return. As the price falls, the position value falls. That means to maximize profits, when they can, more stock gets borrowed and sold as the price falls further.
However, overdoing it by pressing too many shares short, can destroy the opportunity. Overplaying happens meaning even when shorting a bad company, that it is actually possible to be too short!
When that happens, covering profitably becomes impossible. The covering buying pressure with too few shares available, quickly drives prices up to consume all profit. By being too aggressive shorting, the shorts left an inadequate supply of shares for their exit at a profit.
2. Infinite Loss: The opposite occurs when the short play is wrong from the beginning. As the stock price rises the short loss accelerates. It can go to infinity. Best to cover as soon as possible. Ironically adding the cover buying pressure accelerates the price rise. Losses can rapidly soar.
3. Timing: Always, favorable timing makes all the difference. For example, it can happen that a company has years of bad accounting or reporting errors. Shorting too early guarantees a loss. Or the market may not agree with the short seller, that the product is obsolete products or that management is bad. Being too early as a short, gets very costly. Get the timing wrong and nothing else matters. Bad timing means not profitable.
4. Crowded shorts: A potential short seller may see a juicy short opportunity. Before proceeding, astute short sellers check that other players are not already carrying a substantial short interest. When many are short adding further to the short side can quickly become too many. That risks a costly short squeeze or attracts aggressive bull attention seeking opportunity when shorts overplay positions.
5. Unforeseen: While not actually a short phenomenon, unrelated, unforeseen and unforeseeable events happen that can go against the short. Massive market rallies completely unrelated to the target company, industry or market can trigger substantial buying that moves against the short.
That can simply mean bad karma and the short loses on such occasions.
Throughout the series on short selling, I have repeatedly mentioned, short selling is not for novice investors. The White Top View intends to fully explain basic stock market investing to new investors. They and anyone wishing to learn more about financial matters and investing are welcome.
This blog post concludes our basic discussions of selling short.
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These discussions and information intend to help you better understand markets and investing. I am not a financial or investment advisor; opinions are for informational and educational purposes only and are not intended as investment advice. For syndication of the site or blog, please contact info@WhiteTopInvestor.com.
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To read any part of the White Top View series, the Short Story on Short Selling, click the links below:
Part 8, Short selling has rules
Part 10, Four more positives of short selling