Short selling can be a thrilling strategy for investors looking to profit from a stock’s decline, but it’s far from a sure thing. If you’ve ever thought about taking the plunge, it’s crucial to understand the real risks behind it. In short selling, traders borrow shares, sell them at the current market price, and buy them back later, hoping the price drops. While the potential profits are tempting, short selling isn’t as simple as it sounds, and the pitfalls can be devastating.
Imagine betting on a horse to lose—if you’re right, you win big. But if that horse wins, you’re on the hook for much more than your original bet. This is exactly what happens in short selling.
Let’s explore the risks through real-life examples and why you should tread carefully before shorting stocks.
Understanding Short Selling: A Double-Edged Sword
To grasp short selling, picture this scenario: A stock is trading at $100 per share. You believe it’s overvalued, so you borrow 100 shares from your broker and sell them, collecting $10,000. A week later, the stock drops to $80 per share. You buy back those 100 shares for $8,000, return them to your broker, and pocket a $2,000 profit. Easy, right?
But what happens if the stock rises to $120 instead? You’d have to spend $12,000 to buy back the shares you owe, leaving you with a $2,000 loss. Unlike buying stocks, where your downside is limited to the money you invest, short selling can lead to unlimited losses because the stock price can theoretically keep rising indefinitely.
The Crucial Role of a Margin Account: Your Safety Net—or Trap
Short selling requires you to borrow stocks, which means you must have a margin account with your broker. This account allows you to trade on borrowed funds, but it also comes with strict rules. Here’s why it matters: You’re not just borrowing shares—you’re also on the hook for maintaining a certain amount of collateral.
Let’s say you short 100 shares of a stock at $50 each, so your position is worth $5,000. Most brokers require you to maintain at least 30% of the value of the borrowed stock as collateral. In this case, you’d need $1,500 in your margin account. But if the stock price rises to $70, your position is now worth $7,000, and you’d need $2,100 in your margin account to meet the requirement.
Failing to meet this can trigger a margin call, where your broker demands you deposit more funds immediately. If you can’t, the broker will liquidate your position—potentially at a significant loss. This happened to many traders during the infamous GameStop short squeeze in 2021 when the stock unexpectedly soared.
The GameStop Short Squeeze: A Real-Life Nightmare
The GameStop saga is a textbook example of a short squeeze—one of the biggest risks of short selling. In January 2021, hedge funds and individual traders heavily shorted GameStop, expecting its price to fall as the company struggled. However, a group of retail investors banded together on social media and started buying GameStop stock, driving the price up dramatically.
Here’s what happened: Short sellers who had bet against GameStop were forced to buy shares to cover their losses as the price soared. This buying frenzy only pushed the price higher, creating a self-reinforcing loop. GameStop’s stock skyrocketed from around $20 in early January to nearly $500 by the end of the month.
Imagine shorting 100 shares of GameStop at $20 per share, thinking it would drop. Instead, you’re scrambling to buy them back at $300 per share to limit your losses. Suddenly, you’re out $28,000—and if you couldn’t afford the margin call, your broker might have liquidated your entire account. That’s the terrifying reality of a short squeeze.
Dividend Payments: Hidden Costs of Short Selling
Dividend payments are another hidden trap for short sellers. When you borrow shares, you don’t just owe the shares back—you also owe any dividend payments declared while you hold your short position.
Imagine you’ve shorted 500 shares of a company at $50 each. Suddenly, the company declares a dividend of $2 per share. While the stock price might fall slightly after the dividend (as it usually does), you still owe $1,000 in dividend payments to the person who lent you the shares. This can quickly eat into your profits or deepen your losses.
Let’s say the stock price drops from $50 to $45 after the dividend, giving you a $5 per share profit. On paper, you’ve made $2,500. But after paying $1,000 in dividends, your profit shrinks to $1,500. It’s a manageable hit in this case, but when dividend payments pile up, they can ruin what seems like a great trade.
The Unpredictability of Stock Borrowing Fees: The Cost of Playing the Game
In short selling, you also face stock borrowing fees, which vary depending on the stock’s liquidity and demand. Stocks that are difficult to borrow may come with sky-high fees, sometimes over 100% of the stock’s value annually.
For example, during the AMC Entertainment frenzy, some traders paid upwards of 300% in stock borrowing fees to short the stock. Imagine shorting AMC at $10 per share, only to find that your stock borrowing fees have skyrocketed overnight. The higher these fees, the more you pay daily just to keep your position open, turning potential profits into painful losses.
The worst part? These fees can change suddenly, and you might not see it coming. It’s like being hit with an unexpected tax on your trade—one that keeps increasing the longer you hold your position.
Stop Orders: Your Safety Line, but Not Foolproof
Given the wild risks of short selling, many traders use stop orders to limit their losses. A buy-stop order automatically buys back the stock if it rises to a certain price, preventing your losses from getting out of hand. For instance, if you shorted a stock at $80 and place a buy-stop at $85, the order would kick in if the stock rises to $85, closing your position and capping your loss at $5 per share.
Alternatively, you could use a trailing stop order, which moves with the stock’s price. For example, if the stock drops to $70, your trailing stop could follow by $5, meaning if the stock rises back to $75, the stop will trigger. It’s a more flexible way to limit your risk, but stop orders aren’t foolproof.
Stock prices can gap up during market volatility, meaning your stop order might execute at a much higher price than you intended. This can lock in larger losses than you expected. So while stop orders are helpful, they aren’t a guaranteed safety net.
The Risks Are Real—Proceed with Caution
Short selling offers the tantalizing possibility of profiting from a company’s downfall. However, as the examples of GameStop and AMC show, the risks are real, and they can escalate quickly. The combination of margin accounts, short squeezes, dividend payments, and stock borrowing fees makes this strategy one of the riskiest moves in the trading world.
Consider this: You short a stock at $50, expecting it to drop to $40. Instead, it rises to $100. Now, not only are you facing massive losses, but you’re also on the hook for higher borrowing fees, dividend payments, and a potential margin call. Without careful planning, this trade can spiral out of control.
Before engaging in short selling, make sure you fully understand these risks and have a clear strategy to mitigate them. Stop orders can help, but they’re not foolproof. Stock borrowing fees can add up, and dividend payments can sneak up on you. The bottom line? Approach short selling with caution, respect the risks, and be prepared for anything.
Short selling is not for the faint-hearted. For every potential gain, there’s a risk that could wipe out your account.
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This post is originally published on EDGE-FOREX.
