Shorting stocks has risks that must be known, understood and managed including unique risks of selling short. Those risks are beyond the normal market risks that all investors know and deal with. Investors that know of the many risks short sellers cope with, have a deeper understanding of stock market investing.
What you learn:
You learn of skills, vision and understanding that short sellers must have to be effective. The lesson covers many risks of short selling and provides insight and understanding of the complex options short sellers face. Your stock market vision can improve by knowing the short selling process and the risks they manage. By understanding how and why short selling happens, you can be more aware of both risk and opportunity in stock markets which can improve your investing process.
FAQ investors ask about shorting stocks has risks
The Short Story Shorting Stocks course, Lesson 6, shorting stocks has risks begins with the FAQ and answers about what are the short selling risks? Links at the lesson end guide you to related content to learn more.
How can a company defend against short sellers?
When short sellers target a company, they should quickly respond with accurate information that disputes the overvaluation claim.
Even partially true claims by short sellers can spell costly and unpleasant trouble for the company. In response, companies often raise dividends, declare extra dividends, or start a share buyback program, as increasing the cost of an attack can be the best defense.
Companies that come under attack usually try to restate or exaggerate their revenue and earnings and focus on potential growth. Many also try to generate positive media coverage and lobby influential investors.
A few companies respond with legal action or personal attacks, most often unsuccessful, desperate moves; however, there are some entertaining exceptions!
What are the traits of the best short sale targets?
Smart short sellers look for more than just overvalued shares. They know, besides overvalued shares, fraud is the best issue to short sell! As well, in addition to overvalued shares, weak finances, obsolete business or operations, and management blunders also make good short targets.
Characteristics of good short targets include,
1. Frauds, financial weakness, or accounting issues.
2. An obsolete business, dated products or services.
3. Bad management blunders.
Research separates the most successful short sellers from the rest. The best researchers uncover the real story, financial troubles, and selling opportunities.
What risks must short sellers manage?
These seven significant risks are involved in every short-selling trade:
1. Timing Risk: The most crucial skill for short-selling success is making the sale at the right time.
2. Upside Price Risk: Short sellers must quickly cover when they are wrong.
3. Running Cost Risks: Short sellers must manage the increasing daily costs that short sellers must pay.
4. Contrarian Risk: Short sellers often face adverse publicity and reactions.
5. Regulatory Risk: Regulators can ban or stop a short play.
6. Buy Back Risk: Buying to cover can trigger a short squeeze.
7. Execution Risk: All parts of a short-selling play need good execution.
Above all, this complex and dynamic strategy needs excellent timing and execution for the best short-selling success.
Should beginner investors ever sell short?
Anyone new to investing should never sell short. Leave this strategy to experienced investors with a proven track record of trading success.
Successful short sellers have the needed knowledge, skills, vision, and understanding. They know the many short selling complexities and have the skills to manage the high-cost and unique short selling risks. They know how to execute with excellent timing.
Options or inverse ETFs offer an easier way to bet against the market. Like all products using credit, margin, or inverse leverage, they can produce spectacular price gains, but incorrect bets quickly vaporize money.
Only sell short or use specialized products after fully understanding how those costly, high-risk strategies work.
Should you short sell stocks?
For most investors, the answer is no. Short-selling is not for beginners, although traders with an established and profitable record can do well.
Although short-selling is simple in concept, this advanced strategy requires considerable knowledge and experience. When done wrong, short sellers risk losing money, possibly lots of money.
Effective short sellers have the knowledge, skills, vision, understanding, good timing, and excellent execution. Research is the key to success, so they do their homework.
Short sellers must understand and manage a complex process with high costs and unique short-seller risks with perfect timing and sharp execution.
Can you short sell any stock?
In theory, yes, but in reality, no. Selling short is a challenge and at times, it is not possible to find stock to borrow and sell short. In addition, some markets ban short selling and some protect or exempt sectors. As well, this aggressive strategy has many risks. In theory, a poorly played short can have unlimited risk! Although any involved broker would force the short seller to cover should margin limits get reached. Successful short sellers have the knowledge, skill, vision, and broad market understanding to be effective. They understand the process and most often have excellent timing to manage high costs. In addition, short sellers are aware of the other and unique short selling risks they also manage well.
What are the biggest dangers for short sellers?
Short sellers manage three major risk groups with active hands-on and knowledgeable management, including:
1. Execution Risks
Entry and exit trades for maximum profit include nine risks involving trade complexities, all parties involved, and the market influencing factors. The linked lesson details each trade execution risk.
2. Trade Management Risks
Traders must effectively manage three significant short-selling trade risks, including margin call management, psychological risks, and black swans, to protect capital and avoid losses. The lesson for more details.
3. Specific Trade Risks
Each stock selected as a short-seller target has ten unique risks. More on those dynamic, changing risks are part of every entry and exit trade, as detailed in the linked lesson.
The Big Risks and Challenges of Short Selling
Short selling can be a strategy investors use to profit from a declining stock price, but only after they meet the challenge to identify and play a target stock. In addition, short selling also comes with the significant risks of the following challenges that require careful consideration:
1. Market Timing
Short selling relies on accurately predicting that a stock's price will decrease. Timing is crucial, as you need to sell the stock at a high price and repurchase it at a lower price to make a profit.
2. Unlimited Losses
Unlike buying a stock, where the maximum loss is limited to the amount invested, short selling has unlimited potential losses. If the stock price rises instead of falls, you could lose more than your investment should the stockbroker lock in a more significant loss with a forced sell-out.
3. Borrowing Costs
When short-selling a stock, profits get eroded daily by the rising interest and fee costs of shares borrowed from your broker to sell short.
4. Market Volatility
Short selling can be profitable but is hazardous in volatile markets, as short-term future prices or market direction are impossible to predict.
5. Margin Requirements
Brokers require short sellers to maintain a margin, and should the stock price surge, make an immediate cash deposit to cover potential losses and avoid a forced liquidation.
6. Regulatory Risks
Short selling may be banned or restricted in some markets or conditions due to regulatory restrictions that can change without notice.
Despite the uncertainties, short selling can be profitable, but only if executed correctly by investors with a deep understanding of the market, a positive trading record, careful risk management, and the ability to handle potential losses. Inexperienced investors with a low-risk tolerance should not short-sell.
A deeper dive into short selling risks follows below.
Short Sellers Manage Multiple Risks
Short selling is a complex trading strategy of selling borrowed securities and repurchasing them at a lower price later. It can be lucrative, but the risks are complex and require careful management. In theory, short selling exposes the trader to potentially unlimited losses if the stock rises in price rather than falls. However, in reality, lenders sell out positions that are going well offside.
Should the security's price surge unexpectedly, losses can escalate rapidly and be well above the initial amount invested in the trade. Therefore, traders must conduct thorough risk assessments, make adept market analyses, and comprehensively understand the targeted security's market dynamics. Consequently, the most successful short-sellers are experienced and knowledgeable traders who can navigate the following risks:
1. Execution Risks
Execution risks are the fundamentals of executing good entry and exit trades to produce the most profit. The complexities of these trades, the various parties involved, and multiple others that influence the market and the specific stock include the following factors that can affect the short seller's trade executions.
Market Condition Risks
The market environment, including volatility, liquidity, and trading volume, affects trade executions. Highly volatile markets with rapid price changes impact the execution price as market conditions, activity, and liquidity vary throughout the trading day. In particular, the market's opening and closing periods often experience higher trading volumes and volatility.
Liquidity Risks
Buyers and sellers must be available to make markets work and execute trades readily. Highly liquid stocks tend to have tighter spreads and lower transaction costs than illiquid stocks. If the targeted stock has low trading volume, finding buyers to close a position may be difficult, resulting in price slippage and worse-than-expected outcomes.
Market Depth Risks
The number of buy and sell orders at differing price levels measures market depth. Stocks with deeper market depth usually have smoother trade executions, as there are more orders to match against.
Market Dynamic Risks
Market dynamics, such as sudden price or volatility spikes, can lead to unexpected losses for traders unable to exit their positions quickly.
Market Impact Risks
Short sellers must research the market behavior of the exchange and the target stock to determine the likely impact of their entry or exit trades. A large order can influence market prices, especially for less liquid stocks. Traders may employ strategies to minimize market impact, such as using algorithmic trading or splitting large orders into smaller ones.
Order Type Risks
Market, limit, and stop orders are different types of orders to execute trades. A market order executes immediately at the current market price, while a limit order executes at a specified price or better. On the other hand, a stop order only triggers once the price reaches a specified level. Each type of order can produce varying execution results as market conditions change.
Bid-Ask Spread Risk
The bid-ask spread is the difference between the highest bid to buy and the lowest offer to sell. It plays a crucial role in trade execution since wider spreads can result in higher transaction costs for traders.
Order Size Risk
The size of the order relative to the market's liquidity can affect trade execution quality. Large orders may need to be executed over time to avoid significant price impact, challenging a clean, profitable exit.
Regulatory and Compliance Risks
Short-selling regulations include laws and rules to ensure fair and efficient trade executions, security borrowing, or short sale transactions. Those rules and legal requirements include order types, trading hours, and price increments that can differ by exchange and jurisdiction. They can change without prior notice, and penalties or restrictions on trading activity encourage compliance.
2. Trade Management Risks
Well-managed short-selling trades protect capital and avoid the following risks.
Margin Call Risks
Short sellers maintain capital as collateral in their account, known as margin, to avoid a forced liquidation of positions. That covers the risk the lender has by loaning the stock. Should the price of the shorted security rise, a margin call requires the borrower to deposit additional funds to cover potential losses or close the position at a loss.
Psychological Pressure Risks
Short sellers face challenging psychological risks that significantly impact decision-making and risk management. Losses can mount quickly, and there's a natural market bias for prices to rise over time, which can induce stress and emotional strain on short sellers.
Black Swan Risks
Black swan risks are those elusive, unforeseeable events that strike unexpectedly and severely affect a stock or the entire market. For short sellers, these risks translate into sudden and extreme events capable of inflicting substantial losses. Because they are unforeseen, only in the aftermath can investors comprehend the magnitude of these rare and improbable occurrences, whether it's an abrupt market surge, surprising positive developments concerning the shorted asset, or a global incident unexpectedly inflating asset values.
3. Specific Trade Risks
These are the entry and exit trade risks for each specific short target.
Corporate Action Risks
Management of targeted companies can respond to short sellers with multiple cost and risk-raising options. Events such as dividend payments, stock splits, or mergers and acquisitions can affect the price of the shorted asset and create unexpected risks for short sellers.
Borrowing Cost Risks
Short sellers must pay borrowing costs to the lender of the assets, which can increase over time if demand for borrowing the asset rises or the lender demands higher fees.
Counterparty Risk
The short-selling counterparty lends the shares, but a default or failure to fulfill its obligations makes it difficult to close the short position to return the borrowed assets and incur costs. So, assessing the counterparty's reliability, diversifying sources, and using risk management strategies are essential to mitigate those risks. That is particularly true when short-sellers use derivatives or other financial instruments for leverage.
Recall Risk
The securities lender can recall the borrowed assets at any time, regardless of market conditions. That can force the short seller to repurchase shares at a higher price to return the borrowed shares, leading to unexpected losses.
Replacement Risk
When a recalled short seller wants to replace one lender with another, difficulties can arise, especially if the securities are in high demand for short selling. Even when finding a replacement is successful, costs rise. However, expenses and losses still increase if the short seller cannot find replacement securities.
Squeeze Risk
A short squeeze is a rapid price rise as many short sellers rush to cover their positions. This is most often done to limit losses. As a result, buyback demand increases to minimize losses, further inflating the stock price and amplifying losses for remaining short sellers.
Dividend Payment Risks
Short sellers must pay any dividend costs out of pocket for borrowed securities, which adds to overall costs.
Timing Risk
Timing is crucial in short selling. If the security price doesn't decline as anticipated or takes longer to fall, the short seller incurs more borrowing and opportunity costs. Successful short selling hinges on accurately predicting price declines within a specified timeframe.
Crowded Trade Risk
Crowded trades, where too many investors bet on the same outcome or in the same asset, increase volatility and the potential for sharp reversals if sentiment shifts or unexpected news affects the asset price. That can amplify price and market movements in both directions. This risk is common in popular assets or when investors follow the crowd and ignore downside potential.
Covering Risk
Covering profit shrinkage occurs when short sellers close out their short positions as share prices rise, decreasing their profits.
The Risk Management Challenge
Short selling is risky and requires careful consideration, rigorous risk management, and profound market knowledge to assess risks, analyze the market, and understand the targeted security.
Shorting stock risks must be known and understood by investors
7 Risks short sellers face on every sale
Short selling has many more than 7 risks, but we start with these big ones:
- The biggest risk of short selling is timing, timing, timing! Get the timing right and make a fortune or get it wrong and lose it all!
- Short sellers manage unlimited upside price risk against a maximum payoff of a price falling to 0.
- Shorting is expensive with a complex array of costs to manage.
- Shorts stand alone in a contrarian, unpopular strategy.
- Regulator risk – a new regulation that can destroy a play or adds costs.
- Shorts buying back to exit have buy-in price risks on every play.
- Short selling requires discipline and active hands-on management
Shorting stocks has complex risks that investors must know to understand this important force in stock markets. The complications of short selling move that strategy beyond what any beginning investor should consider using. Still this challenging strategy should be known and understood by all investors to know stock markets better.
For their benefit, and to best understand the market, novice investors should know the basics of short selling. This 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.
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.
A very aggressive market strategy
Shorting stocks includes risks such as stirring up management, the market and other investors. Shorting activity usually gets an aggressive response. Shorting starts a serious business on investment fight. Is is not 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 the price has significantly increased.
Tunnel vision disaster
Investors new to short selling, or any other aggressive strategy, can develop a mental tunnel vision one convinced they have a prime ripe target. That can lead to ignoring other possibilities, or worst yet, market signals you have it wrong. Markets do have a nasty way of testing us when we are convinced we have it right and are smarter than the market.
The stock may simply not cooperate and increase in price. It happens and must be considered as a possibility on each short trade. It can be worse than the situation of 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.
Shorting stocks has risks that investors must know including execution risks. You can be making the “right” short bet and still lose money. You must know how to execute well.
Short selling psychological demands
The psychology of shorting stocks is difficult. This demanding strategy taxes the investor mind, emotions and resources. Knowing about more challenging aspects of stock market investing helps you avoid problems, risks and losses. It gives you a better level of understanding stock markets.
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 a perfectly legitimate but psychologically taxing strategy.
Three best short characteristics
Stocks that rank among the greatest short sale candidates have one or more of the following characteristics:
1. Accounting Issues
Fraud is the very best news for a short seller. In other cases, shorts can simply attack a company that has bad management or poor financial controls. Even if correct about bad numbers, shorts are always challenged to get the timing right.
Making a bag of money from short selling takes knowledge, excellent execution, and time.
2. 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.
3. Bad Management
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 actively manage positions
There is no such thing as taking a passive short position. Shorting stocks has risks that investors must know including execution risks. You can be making the “right” short bet and still lose money. As you know from White Top Investor lessons, change in markets is constant and normal.
Changes mean, when shorting a stock, you must know how to execute well and be prepared to actively manage their positions. Playing short is a very hands-on active strategy requiring active management. Shorts get no time off! Advanced topics like the techniques of effectively managing short positions are beyond any basic discussion of shorting and are covered in other lessons.
Management’s counterattack tools
Short sellers must expect a very aggressive counterattack orchestrated by management. Management deploys many weapons without hesitation. Included are:
- Investor relations
- Public relations
- Media relations
- Lobbying public and private investors/influencers
- News releases including fiction and fluff
- Stock buybacks
- Setting or increasing dividends
- Rising dividends
- Accounting manipulation
- Hyped Numbers
- Earning pumps
- Reporting changes
- Stonewalling
- Insults calling out the reasoning and heritage of short sellers!
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. Shorting stocks has risks including the need to know how to respond to each type of counterattack.
5 dangerous short phenomenon
Shorting stocks has risks that investors must know, including how to cope with these financially dangerous phenomena:
1. Shrinkage
As a shorted stock falls, the short seller must press their position to maximize 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 a short position happens. That means when shorting a bad company, that it is actually possible to be too short!
There is much to think about before selling short
When that happens, covering profitably becomes challenging or even impossible. Covering buying pressure, when too few shares are available, quickly drives prices up consuming all profit. By being too aggressive when shorting, too few shares are left for a profitable exit.
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 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 it is 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 an 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.
Shorting stocks has risks that investors must know includes coping with bad karma and losses for unforeseen reasons. It is very challenging to consistently perform well as a short seller.
Interest rates do change
Changing interest rates are included the ‘Unforeseen’ risk because interest rate changes can be a significant cost factor and, most often, rate changes are unforeseen by short sellers.
More and unique short seller risks
As if there are not already enough risk to cope with, short sellers also must deal with several risks unique to short selling. We begin covering those risks by considering the source of the stock that must be borrowed. To sell short we need to find stock to borrow which in itself can be a challenge.
Hard to borrow stock
Short players must be aware of potential issues around hard-to-borrow stock. When brokers have clients holding large amounts of the stock being considered for a short, the supply of stock is said to be easy to borrow. If there are few clients holding the stock or the totals held are smaller amounts, the stock is hard to borrow.
In the case of hard-to-borrow stock, the broker charges more in the form of a daily fee reflecting the price and availability of the stock. The “hard to borrow fee” is one more issue and cost a short seller must know before taking a short position.
Lender wants to sell
When brokers lend short sellers stock to sell, the stock owner is not informed but retains ownership including rights to dividends or to sell at any time. Should the stock owner sell and the broker has other client inventory to loan the short, no problem. The arrangement continues.
However, if there are few other stockholders or limited investors the broker will charge a “hard to borrow” fee and carry on as before, but with the addition of higher cost. On the other hand, if other inventory is not available, the broker will force the short to cover and pay back the borrowed stock. That could get bad, or to be more accurate, expensive!
Such an outcome forces the short seller off the play and let the chips fall where they may! All costs go to the short seller. This could be a situation that you are right, the stock is going down, but being forced off the short turns it into a losing investment move.
Dreaded margin call
Margin calls can come with no notice and completely destroy the short trade and if forced to sell in unfavorable circumstances, can inflict severe portfolio damage.
Short selling risk management
Investors will find that risk management opportunities for shorts are limited and expensive. When prices move against a short position, it gets ugly and costly fast! There are few lifelines. However, there are a couple of possibilities.
Buy stop orders are the first line of risk management defense for short sellers. That order triggers a market order to buy back the stock when the stock trades at or above the stop price.
A more sophisticated order, the trailing buy stop can place more complex order conditions. Explaining these orders in detail could easily develop into a full lesson. It is enough to say stops are no sure thing or a guaranteed exit.
The very best defense for shorts is to be right and relentlessly watch your positions. When you are wrong, or the market goes strongly against you, get out as fast as you can to preserve as much capital as possible.
Market risks of going short
As in any trade or investment, short selling has market risk. That means the price of the stock may move the ‘wrong’ way. In the case of a short seller higher prices hurt.
Short selling is a margin play. That means the short seller carries the liability that comes with borrowing an asset. In the case of a short seller, stock no capital gets borrowed.
As when carrying any liability, time costs money. In the case of borrowing stock, the costs to carry the loan can tip the balance for or against the short seller. A profitable trade can lose money due to costs.
Should the stock price move against the short seller, those losses can rapidly multiply. Such adverse price movement can quickly produce very significant and, in theory, unlimited losses.
Still more short seller risks
In addition to any market risks, short sellers face the risk that the company management may take actions that move stock prices up. Risks of being financially hurt by management’s positive actions are unique to shorting.
For example, declaring a dividend when none existed before, or announcing a dividend increase, can quickly move a stock price up. Such news announcements usually bring a wave of share buying by investors attracted to the dividend.
Such buying pressure can give a stock price strength and most likely pushes the price higher. Sometimes, sharply higher. Exactly what the short seller does not want to happen.
As well, other announcements can hurt, such as new unexpected business or even simply negotiations for a major new business contract. Also, announcements of new products, markets, segments or regions can put company shares in play.
Any company announcing major new business often puts the shares in play and moving higher. In large or small companies, very significant share price movement may result. Such price movements can quickly hurt a short seller.
Strategic review risk
A company struggling with business challenges or under pressure by substantial short selling may announce a ‘strategic review’. That is corporate speak or market jargon meaning the company is for sale. This is certainly one of the unique risks of short selling.
Hanging a “For Sale” sign on a public company certainly attracts attention. In addition to any prospective new controlling or ownership group, such announcements most often attract both investors and speculative interest.
A buying frenzy can result. When it does, there is only one way for the stock price to move. Up! That quickly leaves any short seller, that did not cover, drowning in losses!
Media and news release risks
At times company management and short sellers engage in media battles called dueling news releases. Management news releases point out all the positives and why the company is, or will soon be, doing well.
Short sellers do not always respond with news releases but certainly do respond by freely expressing a negative view of management and the company. Any news releases that do come from short sellers naturally point out what a disaster management has been or why prospects are so dim under the current management.
Company management often feels very deeply and personally motivated; after all, their jobs are certainly on the line! They will consider many actions or announcements to make life miserable, or at least unprofitable for a short seller.
The media loves this stuff! Drama in business or boardroom battles always gets top billing and opens doors for interviews. The court of investor opinion matters because they vote by buying or selling shares in the company.
At times, such battles are as entertaining as any infotainment program available. At times, some combination of bluff, poker and truth or dare get played in rooms, or is it minds, filled with smoke and mirrors! This is the most bizarre of the unique risks of short selling.
Or, could it be you are late getting the news or information? Perhaps what you think the market does not know, has already been priced in. The market may have already digested the news.
Dividend costs add up
Dividend costs are present risks as dividend costs can change. Two changes can happen, either the dividend gets increased or the timing of the short trade is significantly off.
Should the board raise the dividend, costs immediately spike for a short seller! Should the short trade timing be off and the position has to be carried longer than planned, the short seller must possibly cover multiple dividend payments.
In either case, costs escalate. Costs or share price increases have a huge negative financial impact on the short. The short seller has to get it right.
Calendar game risks
The calendar risk can surprise a short. Corporate boards set dividend amounts and dates. It is within their power to change either the dividend amount or date, or both. Naturally, because they can, they do.
The owner of a stock, at the market closing, the trading day before the ex-date, is due any dividend. The ex-date is the first day of a new (future) dividend period.
Buying a stock on the ex-date means the new owner does not receive the previously declared, but not yet paid dividends. The payment delay or real payment of the dividend may happen a few days later. Paying two weeks after the ex-date is a common occurrence.
Here is a nasty bit of gamesmanship. Boards can move the ex-date up the calendar forcing earlier payment of dividends. That can substantially increase the short seller’s costs.
Shorts will certainly call foul! They will launch lawsuits and keep a bunch of lawyers busy as will the company!
Warrant and spinoff risk
The nastier of the unique risks of short selling includes both warrant and spinoff risks. Management can issue warrants to all shareholders. They can sell, disperse or change major parts of the company targeted by the short seller.
That can mean selling assets or divisions or spinning them off to shareholders or to third parties. Making any such moves can vastly change the stock seller values recognized by the market.
It can also move the value away from the short’s position or significantly dilute the ownership value of a share. It can also have the effect of issuing multiple shares in different companies to the same shareholders. That can keep all shareholders happy, except the short seller who sees value melting away.
The word, ‘complicated’ certainly describes the many possibilities. In a flash, the short may find they are now short two or more securities. Suddenly they are holding a far more complex and costly position.
Then, imagine the financial horror if two or more share prices move against the short seller at the same time! When battles get nasty, they get loud. That attracts a crowd.
Share trade volumes very often come alive and the show is on! Bets are made and stock prices can significantly move. Most often up.
Rather than further exploring this complexity and many permutations, the point is, very high risks lurk. Shorting gets complex and carries significant risks. Once you have experience and comfort with markets, you can consider such a strategy. Until then, don’t touch!
The very real short squeeze
When markets move up, even poorly run companies with bad fundamentals can trade at higher prices. Markets, especially in the short term, are not logical or rational. Nutty things such as unjustifiable higher prices can, and do, happen.
A short squeeze happens when short sellers on the wrong side of a rising stock price give in and move to cover. The rising price pressure may even start a buying-panic at the market price in the rush to cover growing losses. That buying can push prices higher, triggering more short covering that again increases buying volume and moving prices higher into an uptrend.
Short squeeze defense
Experienced short sellers avoid short squeezes by avoiding:
Trading techniques and skills also avoid short squeezes by:
Questions Answered!
The fast answer to, what are short selling risks, is many! The lesson covers the risks of short selling and provides insight and understanding of the complex options short sellers face. Your stock market vision can improve by knowing the short selling process. By understanding how and why short selling happens makes you aware of both risk and opportunity in stock markets which can improve your investing success.
Lesson takeaways,
Shorting stocks has risks:
Shorting stocks has risks that must be known, understood and managed including unique risks beyond those of a normal market that all investors know and deal with. Investors that know short sellers cope with those many risks, have a deeper understanding of stock markets.
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Shorting stocks has risks
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Smart investors use smart diversification
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Comments and questions welcome
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Short story shorting stocks:
Short selling stock explained Lesson 1
Short selling improves markets Lesson 2
Short selling improves companies Lesson 3
9 Short seller facts align Lesson 4
Making money selling short Lesson 5
Shorting stocks has risks Lesson 6
Who’s selling your stock? Lesson 7
Short seller skill sophistication knowledge Lesson 8
Short seller cost control Lesson 9
Short selling has rules Lesson 10
Next lesson 7:
Who’s selling your stock?
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Shorting stocks has risks
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Lesson code: 505.06.
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