Monday, August 18, 2008

Why Shorting Is No Good

Occasionally, we have guest authors contribute to this blog. The following post was written by Alex Garcia. Alex regularly writes for Contrarian Value Investing, and runs a portfolio which can be seen here.

Shorting is a common technique on Wall Street as investors try to profit from both rises and falls of particular stocks. But one thing I never really understood is why short in the first place.

Definition of shorting according to

The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Yes, some individuals are successful

Bill Ackman comes to mind as a successful short. I'm pretty sure there are other individuals who have successfully shorted stocks for a living and will continue to do so.


I might not be the smartest man alive, but logic is the main reason I avoid shorting. Here goes:

If I short a stock, my biggest gain will be 100% and my biggest loss could be limitless (assuming I do not get a margin call). On the other hand, if I buy a stock, my gain could be infinity, while my downside is limited to losing my initial investment or 100%. Now that’s what I call controlling my risk/reward.

An example:

On January 2007, David Dreman wrote an article for Forbes titled "Short The Exchanges", in which he considered the following stocks: Chicago Mercantile Exchange (NASDAQ: CME), Intercontinental Exchange (NYSE: ICE), and NYSE Euronext (NYSE: NYX). At the time of writing, CME traded at $530. The stock continued its unprecedented run up to $714. The stock is well off its highs, but an individual would have had to stomach a 35% increase in CME’s stock price.

Alex Garcia is a guest author and regularly writes for Contrarian Investing, and runs a portfolio which can be seen here.


Early Retirement Extreme said...

I often see this "potential to go to infinity" in theoretical discussions. However, in reality, the probability of a price goes down faster than linear as the price increases and a company saturates the market; enough to make the expectation values finite.

Still, I stay away from shorting because I would have to fight drift such as inflation and GDP growth which are typically positive.

plainfont said...

I find most of your posts quite insightful. Bluntly stated, this is not one of them. The risk on shorts is primarily from margin requirements to maintain, and going insolvent before making a buck. The psychological fear of unlimited downside with limited upside leads to longs being far more crowded than shorts, meaning that it is more difficult to find undervalued stocks than it is to find overvalued ones.

In short, by maintaining tight targets and stops, shorts can be just as safe as longs, if not safer.

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