Dear Fellow Investor,
From time to time, I’ll hear from a reader asking if Cabot has any short-selling services. The short answer is no. The long answer is no – and let me tell you why.
Here’s that long answer.
First, let’s make sure we’re all clear on the basics of short selling.
Short selling has the potential to make, or lose, a lot of money for investors. High risks, high rewards. Sounds like the makings of a great Hollywood movie. In fact, several.
If you are at all interested in short selling, you should watch at least two of these movies. The first is the 2015 film The Big Short, hedge fund manager Michael Burry’s investigation into the 2005 U.S. housing market. He discovered that the market was being propped up by risky subprime mortgages and takes a $1 billion+ short position, generating profits of $2.69 billion when the 2008 financial crisis began. A glowing success for a short seller who did significant research and boots-on-the-ground investigation.
The other movie to watch is the 2023 film Dumb Money, about the GameStop short squeeze in the early part of the Covid pandemic. In this film, the so-called “smart money” is short selling GameStop and ends up losing hundreds of millions of dollars. A dramatic example of how badly short selling can go (and it would have been even worse had Robinhood not yielded to pressure from big money interests – assistance you and I are not going to get).
By the way, each of these movies is based on great books – The Big Short by Michael Lewis and The Antisocial Network by Ben Mezrich – if that’s your preferred medium.
Takeaways:
- Short selling profits from falling prices.
- Requires deep research and active risk management.
- Very risky with potential for unlimited loss.
- Not recommended for most investors.
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Short selling—profiting from the decline of a security’s price—is one of the most advanced, controversial, and potentially risky strategies in the investing world.
While most investors focus on buying assets they believe will rise in value, short sellers bet against overvalued or fundamentally weak stocks, aiming to profit as prices fall.
Short selling, or “shorting,” is the process of borrowing shares of a stock (or another security) from a broker and selling them on the open market, with the intention of buying them back later at a lower price.
If the price drops, the short seller buys the shares back at the lower price, returns them to the broker, and pockets the difference. If the price rises, the short seller must buy back the shares at a higher price, resulting in a loss[1][2][3][4][5].
Because of the high risk, the perception concerns, and the potential for manipulation, I do not recommend short selling for most investors. But a well-educated investor should be aware of short selling and its role in investing.
For example, if you believe Stock XYZ, currently trading at 100, is overvalued, you could borrow 100 shares and sell them for $10,000. If the price drops to 80, you buy back the shares for $8,000, return them, and make a $2,000 profit (minus fees and interest). If the price rises to 120, you must buy back at $12,000, incurring a $2,000 loss (plus fees and interest)[2][5]. If the price rises to 200, you lose your $10,000 plus $10,000 more.
Short selling is fundamentally a bearish or contrarian strategy. It can be used for:
- Speculation: Profiting from anticipated declines in specific stocks or sectors.
- Hedging: Offsetting potential losses in a long portfolio during market downturns.
- Market efficiency: Helping correct overvalued stocks and expose fraud or weak fundamentals[3][6][7].
Many people think short selling is “shady” for several interconnected reasons, rooted in both the mechanics of short selling and the perceptions and emotions it provokes among investors and the public.
Short sellers profit when a stock’s price falls, which means they benefit when companies struggle or fail. Many people see this as “cheering for failure,” which feels contrary to the spirit of investing, where most hope for companies to grow and succeed[1].
A falling share price can harm not just investors, but also employees, management, and the broader community. Critics argue that short selling can increase a company’s cost of capital, trigger margin loan pressures, and even make a company vulnerable to takeovers or regulatory breaches[2].
Some short sellers have been accused of unethical practices, like “short and distort” schemes—spreading negative rumors or misleading information to drive a stock’s price down after taking a short position[3][1].
This can create a self-fulfilling prophecy and is seen as predatory. Similarly, coordinated short selling can, in theory, exacerbate price declines and destabilize markets, especially during times of stress or for smaller companies[4][5]. This can undermine investor confidence and is sometimes blamed for market crashes or company failures.
And there are practical reasons for being wary of shorting. Short selling exposes investors to theoretically unlimited losses if the stock price rises, leading to dramatic “short squeezes” where forced buying by short sellers drives prices even higher[6]. These events can cause extreme volatility, which is unsettling for the broader market.
For many investors, there’s a philosophical discomfort with profiting from decline or disaster. Some view short sellers as “villains” who are adversarial to the hopes and dreams of long investors and the companies themselves[8][1].
Many people don’t realize that short sellers can help expose fraud (e.g., Enron), correct overvalued stocks, and improve market efficiency by providing liquidity and aiding price discovery[4][9][10]. When a stock declines, it’s easier to blame short sellers than to accept that a company may be fundamentally flawed or overvalued[8].
In addition, high-profile short-selling campaigns, especially those that target beloved or widely held companies, often attract negative press and public backlash. During market crises, regulators sometimes restrict short selling, reinforcing the perception that it is dangerous or destabilizing[7].
Short selling involves profiting from decline, is susceptible to manipulation and volatility, and is frequently misunderstood or misrepresented in public discourse. While it plays a vital role in healthy markets by exposing overvaluation and fraud, its association with market downturns, ethical concerns, and high-profile controversies keeps its reputation controversial[3][4][8][2][1][9].
How to Short a Stock
- Open a Margin Account: Short selling requires a margin account with your broker, as you’re borrowing shares and must maintain collateral (typically 150% of the short position’s value)[2][4][5].
- Identify a Target: Use fundamental or technical analysis to find overvalued stocks or those with deteriorating prospects.
- Locate Borrowable Shares: Your broker must have access to shares you can borrow. Some stocks, especially small-caps or heavily shorted names, may be “hard to borrow,” increasing costs[2][8][5].
- Place the Short Sale Order: Enter a “sell short” order for the desired number of shares. You may use market or limit orders.
- Monitor the Position: Actively track the stock price, market news, and your margin balance. Be prepared for margin calls if the price rises[4][5].
- Close the Position: Buy back (cover) the shares and return them to the broker. Your profit or loss is the difference between the sale and repurchase price, minus costs[2][3][4][5].
7 Short Investing Strategies (for Experienced Investors)
1. Short Rallies, Not Sell-Offs
Wait for a temporary rebound (countertrend bounce) within a downtrend, then short as momentum turns negative. This increases the odds of entering at a better price and reduces the risk of a sudden reversal[9].
2. Target Weak Sectors and Stocks
Focus on sectors or stocks already in a downtrend, rather than trying to “call the top” of strong performers. Weakness often persists, and these names may have lower short interest, reducing the risk of a short squeeze[9].
3. Use Technical Indicators
Look for breakdowns below support levels, bearish moving average crossovers (e.g., 50-day below 200-day), or negative momentum signals (e.g., MACD crossovers)[9][5].
4. Trade Within Ranges
Short near the top of a trading range and cover near support. If the stock breaks below support, consider adding to the position[9].
5. Avoid Bullish Seasonality and Low Volume
Don’t short during periods of low liquidity (holidays, options expiration weeks) or when bullish seasonal trends are in play. Thinly traded markets can produce unpredictable moves[9].
6. Short in Conflicted Markets
Bearish divergences between major indexes can set up short opportunities, especially when they later align and point downward[9].
7. Use Derivatives for Leverage or Hedging
Options (buying puts or selling call spreads) and futures can provide leveraged short exposure with defined risk[10][11].
The Risks of Short Selling
Short selling is inherently riskier than traditional “long” investing.
Key risks include:
- Unlimited Loss Potential. If a stock’s price rises, losses can be infinite, as there’s no cap on how high a stock can go. In contrast, the maximum gain is limited to the initial short sale proceeds[3][6][7][12][13][5][14][15].
- Short Squeezes. A rapid price rise can force short sellers to cover their positions en masse, driving the price even higher. Famous examples include GameStop (2021) and Volkswagen (2008)[3][6][13][8][15].
- Margin Calls. If the value of your short position rises, your broker may require additional funds. Failure to meet a margin call can result in forced liquidation at a loss[2][7][4][13][5][15].
- Borrowing Costs and Dividends. You must pay interest on borrowed shares, “hard to borrow” fees, and reimburse any dividends paid while you’re short[7][13][8][5].
- Market Trend Bias. Markets tend to rise over the long term, so the overall trend works against short sellers[3][6][7][14].
- Regulatory and Liquidity Risks. Regulators may restrict short selling in volatile markets. Illiquid stocks can be difficult to cover without moving the price against you[1][2][3][13][8][5].
- Compounding Mistakes. Losing short positions grow as a percentage of your portfolio, increasing pressure and the temptation to make emotional decisions[6][13].
Practical Tips for Short Investors
- Risk Management Is Crucial: Use stop-loss orders, position sizing, and regular monitoring to cap potential losses[9][1][12][5].
- Be Aware of Margin Calls: If the stock price rises, you may need to deposit more funds or close your position at a loss[1][2][4][13].
- Account for All Costs: Short sellers pay interest on borrowed shares, “hard to borrow” fees, and must cover any dividends paid during the short[7][4][13][8].
- Understand Regulations: The SEC and other regulators may restrict short selling during crises or for certain stocks. Naked short selling (selling shares you haven’t borrowed) is generally prohibited[1][2][3].
- Stay Informed: News, earnings, and market sentiment can quickly reverse a stock’s direction. Monitor your positions closely.
- Practice First: Use paper trading or small positions to gain experience before risking significant capital[4].
Potential Benefits of Short Selling
| Benefit | Description |
| Profit in Falling Markets | Short selling allows gains during market declines or in bear markets[3][6][7][8]. |
| Hedging Tool | Can offset long positions and reduce portfolio risk[3][7][8]. |
| Market Efficiency | Helps correct overvalued stocks and exposes fraud[3][6][7]. |
| Increased Liquidity | Short selling boosts trading volume and market liquidity[3][6][7][8]. |
| Leverage | Margin allows larger positions with less capital[3][6][7][8]. |
| Flexibility | Enables opportunistic investing and contrarian strategies[6][7][8]. |
Potential Drawbacks of Short Selling
| Drawback | Description |
| Unlimited Losses | Losses can exceed initial investment if the stock rises[3][6][7][12][13][5][14][15]. |
| Short Squeezes | Forced buying can drive prices sharply higher[3][6][13][8][15]. |
| Borrowing and Margin Costs | Interest, fees, and dividend payments reduce profits[7][13][8][5]. |
| Regulatory Risks | Short selling can be restricted or banned in crises[1][2][3]. |
| Market Bias | Long-term market trend is upward, working against shorts[3][6][7][14]. |
| Emotional and Compounding Losses | Losses can grow and pressure investors into poor decisions[6][13]. |
| Limited Upside | Maximum gain is capped at 100% (if stock goes to zero)[7][5]. |
| Complexity | Requires advanced knowledge, constant monitoring, and fast execution[1][2][3][4][13][5]. |
Tips for Managing Short Selling Risk
- Do Your Research: Because of the high risk of loss, successful short sellers don’t take a short position lightly. They have a thesis about why a stock is going to fall and they research closely to see that their thesis holds up.
- Use Stop-Loss Orders: Set automatic buy orders to cap losses if the stock rises past a certain level[9][12][5].
- Limit Position Size: Don’t overcommit capital to any single short position.
- Diversify: Short across sectors or stocks, not just one name.
- Monitor Margin Closely: Be ready to add funds or reduce positions if prices move against you.
- Stay Liquid: Have cash or margin available to meet potential calls.
- Cover Quickly if Wrong: Don’t let losses compound; exit losing trades promptly.
For those looking to get exposure to some of the benefits of shorting while managing their risk there are a number of ways they can consider:
- Put Options: Buy puts to profit from declines with limited risk[10][11].
- Inverse ETFs: Invest in funds that rise as the underlying index falls.
- CFDs and Futures: Use contracts for difference or futures contracts to speculate on declines, often with leverage[16][11].
- Pairs Trading: Go long one stock and short another in the same sector to hedge risk.
Short selling is best suited for experienced traders with a high risk tolerance, active investors who monitor positions closely, those with access to deep research and analytical skills and tools, and importantly those able to absorb substantial losses.
To be clear, I do not recommend short selling for beginners, passive investors, or those unable to withstand large, rapid losses.
In addition to the high risk of potentially unlimited loss, because of the real opportunity for manipulation, the practical need to perform deep research and to very closely monitor open positions, the mixed reputation of short sellers and the controversial aspects of short selling, Cabot does not include short selling among the strategies we offer guidance on. That’s not to say it can’t be profitable. We just think there are plenty of other investing strategies from which to choose that don’t bring all that baggage.
Always consult with a financial advisor before engaging in short selling or other advanced trading strategies.
Short selling is a powerful but risky tool for profiting from falling prices, hedging portfolios, and adding flexibility to investment strategies. While it offers unique opportunities, it comes with the possibility of unlimited losses, margin calls, short squeezes, and high costs.
Successful short investors use disciplined strategies, rigorous risk management, and constant vigilance. For most investors, short selling should be approached with caution, practiced first with paper trading, and used sparingly (if at all) within a diversified portfolio.
What are your thoughts on short selling? Do you have experience short selling? How did it go for you? Email me at support@cabotwealth.com. I welcome your comments.
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References
1. https://www.fidelity.com/viewpoints/active-investor/selling-short
2. https://www.investopedia.com/articles/investing/100913/basics-short-selling.asp
3. https://www.businessinsider.com/personal-finance/investing/what-is-short-selling
4. https://www.nerdwallet.com/article/investing/shorting-a-stock
5. https://www.investopedia.com/terms/s/shortselling.asp
6. https://money.usnews.com/investing/articles/should-you-consider-short-selling-pros-cons
7. https://www.bankrate.com/investing/short-selling-how-to-short-a-stock/
8. https://www.poems.com.sg/glossary/financial-terms/short-selling/
10. https://www.schwab.com/learn/story/market-downturn-three-ways-to-short-market
11. https://www.home.saxo/learn/guides/trading-strategies/how-to-short-stocks-the-right-way
12. https://www.schwab.com/learn/story/ins-and-outs-short-selling
13. https://wealthdesk.in/blog/short-selling/
14. https://www.investopedia.com/terms/s/shortsale.asp
15. https://www.deskera.com/blog/short-selling-risks-and-rewards/
16. https://www.ig.com/en/trading-strategies/how-to-short-sell-stocks-181115
