Most investors know that there are two basic ways to make money in the stock market. A stock price goes up, and certain companies pay dividends. But there is actually a third way to make money, which is to go “short.”
While short selling is a frequently utilized method of benefiting from market downturns, it is a very risky practice, and is only suitable to the most sophisticated investors who are not afraid to take outsized risks.
The Basics of Short Selling
Essentially, going short is the opposite of going long, in which an investor buys a stock in the traditional sense. Selling short involves an investor making a bet that a stock price will go down. The mechanics of short selling are fairly complex.
In order to go short, an investor needs their broker to lend him or her shares from an existing long position, or from the broker’s own inventory. The investor then sells those shares, hoping to buy them back at a lower price. Eventually, the investor must buy back those shares, so as to close the position. This is commonly referred to as covering a short.
Furthermore, when an investor goes short, they are required to pay the original shareholder any dividends that they are entitled to. So, if an investor goes short a stock that pays a 4% dividend, the short position must pay that 4% dividend out of his or her own pocket.
To be sure, there have been cases in which investors have made fortunes going short the stock market, a particular asset class, or individual securities. For example, in 2008 hedge fund manager John Paulson made $15 billion for his firm by shorting subprime mortgage securities.
However, investors should know the significant risks of going short, particularly when leverage is involved.
Beware of Using Margin
In an effort to enhance returns, some investors choose to use margin when selling short. Since the possible upside of taking a short position is maxed out at 100%, certain investors try to amplify returns even further by borrowing funds to take an even bigger position.
Going short on margin involves a broker lending the investor a portion of the funds at the time of purchase, with the security itself acting as collateral. When an investor does this, they can hold the short for an extended time, but interest is charged on margin accounts, so a prolonged short will be more costly.
Plus, the investor going short does not always control how long they hold the short position. A margin account allows a broker to liquidate an investor’s short position, if the broker no longer feels confident the short seller will return what they have borrowed. This is referred to as a margin call.
Moreover, investors should know that even a well-founded bearish thesis can be upended if the unexpected occurs. That is exactly what happened to legendary hedge fund manager David Einhorn. His firm, Greenlight Capital, famously made headlines when it announced a large short position in Keurig Green Mountain (NASDAQ: GMCR).
Einhorn published an investor letter in October in which he notified investors his firm had taken a sizable short position in Keurig Green Mountain, at an average price of $102 per share. This short position had worked well for the firm, as shares of Keurig had fallen to $52 per share amid falling sales and claims of questionable accounting practices for the at-home coffee brewing machine manufacturer.
But on Dec. 7, investment firm JAB Holding Co. said it would pay $13.9 billion to acquire Keurig, and the stock proceeded to skyrocket nearly 80% to its current level of $90 per share. This effectively wiped out most of Greenlight Capital’s gains.
The key takeaway for investors is that sometimes, finding a beaten-down stock with deteriorating fundamentals isn’t enough to profit from short selling. Unanticipated events such as a buyout of a troubled company can blow up a short position. As a result, short selling may be best left to seasoned investors with an appetite for risk.
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