Short Circuit: Here’s Why I Don’t Short-Sell Stocks

Betting that a stock will go down can be an intriguing proposition. The rewards for being right could be life-changing – but the consequences of being wrong could be life-ruining.

If you short-sell or “short” a stock, you’re hoping to borrow shares from your broker, sell them to a stock trader at a high price, and buy those shares back later on at a lower price for a profit. It’s basically a “sell high, buy low” type of strategy.

It’s not easily sustainable for the long term since the broker will charge you a borrowing fee. When there aren’t many shares of the stock available, the annual borrowing fees can be 100% or even more than that. So, even if you get the trade “right,” you could still end up losing money in the end.

Another potential problem is that there are short squeezes, in which the price of a shorted stock can go up sharply, and then short sellers are forced to buy back their shares because they’re losing too much money. This can result in the share price going even higher very quickly, resulting in even faster losses for the short sellers.

Courtesy: CenterPoint Securities

Don’t assume that you’ll have enough capital to cover a short position that goes against you during a short squeeze. For one thing, a stock has a lower limit of zero but theoretically has no upper limit; the stock price could just keep going up and up indefinitely.

Moreover, your broker won’t just allow you to continue mounting up your losses and owing them more and more money. They’ll only let you borrow so much money to cover the rising cost of the shares during a short squeeze, and at some point, they’ll force you to close out your short position at a substantial loss.

In a worst-case scenario, not only could your brokerage account get wiped out to zero, but you could end up owing a large amount of money to your broker. Thus, the steep losses of a short squeeze could affect you for many years to come.

Granted, it can be tempting to enter into short positions when a stock has gone very high. You might envision becoming a top-calling hero on social media if you make big money short-selling as the share price reverses and heads back down.

That’s one scenario that might or might not play out, though calling the top of a stock-price move is a tough game to win. Just look at the long-term charts of NVIDIA stock or Tesla stock, and you’ll see how a stock can keep going up irrespective of a company’s valuation.

Courtesy: StockCharts

An even more dramatic example would be Wolfspeed (WOLF) stock. Wolfspeed was a bankrupt company but, not long ago, it exited out of Chapter 11 bankruptcy and WOLF stock traders went on a buying spree.

If you can believe it, the share price of Wolfspeed stock soared 1,686% in a single day on September 29. Without a doubt, at least some of the WOLF stock buying activity was related to the forced covering of short positions.

Just try to imagine what it would have been like to hold a short position in WOLF stock and when that massive rally occurred. From a financial standpoint, it would have been devastating.

The Wolfspeed stock example is rare, but it’s an example of what could happen. Short squeezes have also happened to the stocks of Gamestop, AMC, Bed Bath & Beyond, and others.

That’s why I don’t try to be a short-selling hero and call the exact top of a stock-price move. If I feel that a financial asset is too richly valued, I might just avoid it altogether as there will always be other opportunities in the markets. In the end, I’d rather be profitable and boring than a broke hero.