The risk and benefits of shorting

Short selling, the practice of wagering that a stock price will move down rather than up, has been a feature of stock markets for hundreds of years. In fact, short selling has existed ever since the world’s first stock markets emerged in the Dutch Republic in the early 1600s. In this insight we look at the benefits and risks of shorting.

What are the benefits?

When we have a bullish view on a company, we can buy the shares in anticipation of being able to sell at a higher price. What if we have a bearish view, for example we may have uncovered accounting fraud, managerial malfeasance, or simply believe a company will miss their earnings guidance? If we are a long-only investor we can only watch from the sidelines as our view is borne out (or not). If we are able to short companies however, we can take short positions and profit if the price goes down. In this sense, shorting magnifies the opportunities for investors to profit. So, for example, the Plato Global Net Zero fund shorted Delivery Hero (German online food delivery) in early September. Inflation was ticking up aggressively, competitors were proliferating like Gremlins¹ in a La Niña year, and consumers wanted to get off the couch and get to Oktoberfest (strange as it is, beginning mid-September each year). What’s more, Delivery Hero had some twelve Red Flags on Plato’s proprietary Red Flag system. Since then, the stock price has dropped 61% (producing a 61% gain for the fund).

When we short a million dollars of a company, we actually generate one million dollars of capital that can be used to top up our best ideas on the long side, magnifying the alpha (outperformance) we can generate.

An additional benefit of shorting is the ability to hedge out market or industry specific risks. Cast your mind back to June 29^th, 2007. Steve Jobs has just unveiled the iPhone 1.0. As you take a pause from playing Snake on your Nokia 3310, you have an epiphany: the iPhone is going to herald a whole new world of ecommerce, social media, and procrastination and your faithful Nokia is destined for the scrapheap. You immediately fax your broker a short order for $1 million of Nokia and with the proceeds go long $1 million of Apple. Because both Apple and Nokia are both exposed to market risk and the consumer discretionary sector, you have largely hedged out these risks with your offsetting long and short positions. Five years later, your Nokia short position has generated a profit for you of $922,153 and your Apple long position a profit of $3,784,813. Nicely done.

What are the risks?

When you buy a stock, your loss is capped out at the amount you invested if the price were to go to zero. When you short a stock, the potential loss is theoretically unlimited. Further, in contrast to a long position, short positions grow larger when the price moves against you. The price can move against you for any number of reasons. Even if your analysis is sound, as John Maynard Keynes famously remarked, “Markets can stay irrational longer than you can stay solvent”. Short squeezes where everybody rushes to the exits and covers their positions at the same time can lead to painful short-term underperformance. Short squeezes can happen for rational reasons or be driven by “animal spirits”. The so-called meme stocks, Gamestop, Bed, Bath and Beyond, and AMC are just the most recent incarnations of this phenomenon. Position sizing and robust risk management are even more important on the short side.

¹ Not sure if the 1984 horror film reference is showing my age or just my bad taste in movies.